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

2 . Completed Contract method

US GAAP vs. IFRS

  1. Long-term construction contracts when outcomes can be reasonably estimated:
    1. The percentage-of-completion method is used under both IFRS and GAAP.
    1. US GAAP: Must use Completed Contract Method (No revenue or expense is recognized until the end of the contract)
    2. IFRS: Must use the zero-profit method (revenues are recognized only to the extent of costs)
    1. US GAAP: Follow specific industry guidance for revenue recognition
    2. IFRS: Typically use the % Completion method (or straight-line if services are specified over a period of time)
    1. Loss (if expected) must be recognized immediately under both IFRS and GAAP

    Example

    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.

    Year201120122013
    Cost Incurred$350,000$175,000$175,000

    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.

    Year201120122013
    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
    Expenses$350,000$175,000$175,000
    Profit$150,000$75,000$75,000

    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:

    Year201120122013
    Revenue$350,000$175,000$475,000
    Expenses$350,000$175,000$175,000
    Profit00$300,000

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