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

• The percentage-of-completion method recognizes revenue on a long-term project as work progresses.
• Revenues, expenses, and gross profit are recognized each accounting period based on an estimate of the percentage of completion of the project. 
• The percentage of completion is generally measured by dividing the total cost incurred till date divided by the most recent estimate of the total cost of the project.
• Project costs and gross profit to date are accumulated in the inventory account (construction in progress.) 
• Progress billings are accumulated in a contra inventory account (billings on construction in progress)

2. Completed Contract method

• Revenues, expenses, and resulting gross profit are recognized only when the contract is completed. 
• As construction costs are incurred, they are accumulated in an inventory account (construction in progress). 
• Progress billings are not recorded as revenues, but are accumulated in billings on construction in progress account that is deducted from the inventory account (i.e., a contra account to inventory). 
• At the completion of the contract, all the accounts are closed, and the entire gross profit from the construction project is recognized.

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.

2. Long-term construction contracts when outcomes cannot be reasonably estimated:

   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)

3. Service Revenue