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Recognizing Revenue for Long Term Contracts.docx

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University of Alberta
Kristie Dewald

Recognizing Revenue for Long-term contracts We previously learned that in order to recognize revenue in the income statement, 3 criteria need to be met: - Performance is substantially complete - Revenues and relates expenses are known or estimable - Collection is reasonably assured In certain situations, the “performance” criterion is satisfied over more than one accounting period. These are termed long-term contracts. These would be common in the construction industry, for example. The problem with long-term contracts is that waiting until the goods are delivered at the end of the contract may not best reflect the efforts or activities of the business, as will be demonstrated with examples below. There are 2 methods permitted for recognizing the revenue when a long-term contract is involved: 1. The completed contract method, and 2. The percentage of completion method 1. Completed Contract method (this is not permitted under International Financial Reporting Standards, but is permitted under Private Entity Standards) Under this method, revenue (and the related expenses) are not recognized until the contract is completed. This method is generally used in situations where the contract period is reasonably short. Example: Assume New Construction Company (NCC) begins operations on January 1, 2009. At that time, the company is able to secure 3 contracts for projects that total $15 million in revenue. Costs related to the projects are expected to be $9 million. All projects will take 3 years to complete. Assuming actual experience is consistent with expectations, under the completed contract method, NCC would delay recording any revenue on these projects until 2011, when the projects are completed. Because of the matching principle, the related costs would also be recognized in 2011. The income statements for the 3 years of construction would appear as follows: 2009 2010 2011 Revenue 0 0 15,000,000 Cost of sales 0 0 (9,000,000) Gross profit 0 0 6,000,000 Accounting 311/dewald The problem with this is that it looks like the company has been doing nothing during 2009 and 2010, which is not correct. So we could say that, in this situation, the completed contract method produces financial information that does not best reflect the activity or operations of the business. This policy could be utilized by companies that have more short-term contracts. For example, home building companies will generally be able to build a house in less than one year. This type of policy, then, might make better sense for that type of operation. It is simpler to use, and if the project is started and completed within one fiscal period, the results of this method are the same as if the percentage of completion method was used. Percentage of completion method To resolve the problem noted in the above example (where the results do not reflect the effort), an alternative method is available. Under the percentage of completion method, companies will recognize portions of the revenue and related expenses in each of the years that work is performed. The amount of revenue that is recognized is related to the percentage of the work completed in a particular year. There are several possible ways that we could measure “percent complete”. For example, we could measure that based on time (construction will take 3 years, so after year 1, it would be considered 1/3, or 33% completed); based on amount of building completed (5 floors of a 10 floor building are done, so 50% complete); etc. However, the most common way that we measure completion is based on the amount of costs incurred. If a project is estimated to cost $8 million, and at the end of year 1, $2.5 million has been spent, we would consider the project is 2.5 million/8 million = 25% complete, since 25% of the total expected costs have been incurred. This is the method we will use for our course. Once we know what percentage has been completed in a year, we simply apply that percentage to total revenue expected to determine the amount of revenue to record in a particular year. Example: Continuing with the example of New Construction Company….Information on NCC’s 3 projects is as follows: Total revenue: Project A - $8,000,000 Project B – $4,000,000 Project C – $3,000,000 Costs are expected to be incurred as follows: 2009 2010 2011 Total Project A 3,500,000 1,000,000 500,000 5,000,000 Project B 500,000 1,000,000 1,000,000 2,500,000 Project C 750,000 500,000 250,000 1,500,000 Accounting 311/dewal
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