What it means
Imagine a builder who takes three years to construct a hospital. If the company waited until handover to record any revenue, the first two years would show only costs and losses, and the third would show a huge profit.
Neither would describe the real performance of the business. The modern approach, set out in the revenue standards used under US accounting rules and IFRS, recognises revenue over time when the customer controls the asset as it is built or the company has an enforceable right to payment for work done.
Progress is measured using a method that reflects the transfer of value to the customer. The most common is the cost-to-cost method, which compares costs incurred so far with total expected costs.
Under cost-to-cost, the percentage complete is multiplied by the total contract price to give cumulative revenue. The revenue for the period is the cumulative figure less what was recognised earlier.
Costs are expensed as they are incurred, so profit emerges in step with the work. Estimates drive the whole system, so they need careful review.
If the expected total cost of the contract rises, the percentage complete falls and a catch-up adjustment is recorded in the period of the change. If a contract is expected to make a loss overall, the whole expected loss is recorded straight away rather than spread over the project.
Billing and revenue seldom match. When revenue recognised is greater than billings, the difference is shown as a contract asset, and when billings are greater than revenue it is a contract liability.
Readers of the accounts should look at these balances along with cash flow, because a profitable contract can still strain cash if the customer pays slowly. Disclosures help readers judge the estimates.
Companies typically explain how they measure progress, show the balance of contract assets and liabilities, and report the value of work still to be performed. These notes allow an analyst to see how much future revenue is already contracted.
In practice
Real-world examples
Example 1
A shipbuilder takes four years to deliver a vessel to a customer. Each year it recognises revenue based on the share of expected costs incurred. The accounts show steady profit instead of a spike at delivery.
Example 2
A software firm builds a bespoke system over 18 months for a bank. It recognises revenue as it completes the work, using hours worked as the measure of progress. A change in scope increases the total expected hours, and the percentage complete is revised.
Example 3
A road construction company expects a contract to lose $1,500,000 overall because of rising materials costs. It records the full loss immediately in the period it becomes expected. This prevents the early years from showing profit that will later reverse.
Think of it
Imagine baking a massive wedding cake that takes a week to complete. Instead of getting paid only when the cake is handed over on Saturday, you get paid in daily installments based on how many layers you successfully bake and decorate each day.
Formula
Calculation
Percentage complete = Costs incurred to date / Total estimated costs
Revenue to date = Percentage complete x Contract price
A contractor has a $10,000,000 contract with total estimated costs of $8,000,000. At the end of year one it has incurred $3,200,000 of costs, so the percentage complete is 3,200,000 / 8,000,000 = 40%. Revenue recognised is 0.40 x 10,000,000 = $4,000,000. Gross profit for the year is 4,000,000 - 3,200,000 = $800,000, which is 40% of the total expected profit of 10,000,000 - 8,000,000 = $2,000,000.Case study
Seen in the real world
Pillarstone Civil Engineering is an illustrative, fictional company that won a $30,000,000 contract to build a bridge. At the end of the first year its estimate of total cost was $24,000,000, and it had spent $6,000,000, so it recognised 25% of the revenue, or $7,500,000. The accounts showed a profit of $1,500,000 for the year.
In year two, a geological surprise raised the estimated total cost to $27,000,000. The percentage complete at that point was lower than expected, and a catch-up adjustment reduced the profit recognised. The illustrative lesson was that every estimate has to be reviewed each period, and that the early profit was provisional, not guaranteed.
Watch out
Common mistakes
- Using the billing schedule to decide how much revenue to record, when revenue should follow the progress of the work.
- Failing to update the estimate of total costs, so the percentage complete and profit are wrong.
- Spreading an expected loss over the life of the contract, when the whole loss must be recognised at once.
Questions
People also ask
Is long term contract accounting the same as the percentage of completion method?
The percentage of completion method is the traditional name, and the current standards achieve a similar result by recognising revenue over time.
What is a contract asset?
It is the right to payment for work done that has not yet been billed, shown on the balance sheet.
Can a company use the completed contract method?
Only in limited cases under current rules, usually where revenue cannot be recognised over time.