How to Account for Estimates on Long-Term Contracts

Long-term contracts, common in industries like construction, aerospace, and specialized services, extend over multiple accounting periods. A construction company, for example, might take three years to build a large commercial facility. Recognizing all revenue and profit only when the project is complete would distort the company’s financial performance.

To provide a more accurate reflection, accounting for these contracts relies on estimates. By estimating the total revenue and costs over the life of the project, a business can systematically recognize portions of the revenue and profit in each period the work is performed. This approach matches income recognition with the ongoing effort to generate that income.

The Modern Framework for Revenue Recognition

The primary guidance for recognizing revenue from customer contracts is found in Accounting Standards Codification (ASC) Topic 606. The core principle of ASC 606 is that a company recognizes revenue to show the transfer of goods or services in an amount that reflects the payment it expects to receive. This transfer occurs when the customer gains control of the good or service.

Under ASC 606, revenue can be recognized over time if the contract meets at least one of three criteria. The first is met if the customer simultaneously receives and consumes the benefits of the company’s performance as it occurs, such as with a recurring cleaning service.

The second criterion applies if the company’s work creates or enhances an asset that the customer controls as the asset is created. A common example is building a structure on a customer’s land, where the customer controls the partially completed building. The third criterion is met if the performance creates an asset with no alternative use to the company, and the company has an enforceable right to payment for work completed to date, which often applies to highly customized goods.

If any of these conditions are satisfied, the company must recognize revenue over the life of the contract. This allows for a periodic recording of revenue that reflects the continuous work being performed, providing a more faithful representation of a company’s financial activities.

Key Estimates and Their Initial Determination

At the beginning of a long-term contract, a company must establish the foundational estimates that will drive revenue recognition. All subsequent accounting for the contract will be based on these figures until they are formally revised.

Total Estimated Contract Revenue

The first estimate is the total transaction price, which is the revenue the company expects for completing the contract. This price must account for variable consideration, which includes amounts that can change based on future events like performance bonuses, penalties for delays, or incentives.

To estimate variable consideration, a company uses one of two methods. The “expected value” method calculates a sum of probability-weighted amounts from a range of possible outcomes. The “most likely amount” method involves selecting the single most likely outcome from a range of possibilities and is better for contracts with only two possible outcomes, like receiving a bonus or not.

Total Estimated Contract Costs

The second estimate is the total cost expected to be incurred to fulfill the contract. This requires a comprehensive budget of all anticipated expenditures, which are categorized to ensure a complete forecast.

• Direct materials includes the cost of all raw materials and components that will become a physical part of the final project.
• Direct labor costs are the wages and benefits paid to employees who work specifically on the contract.
• Subcontractor costs represent payments made to other companies hired to perform specific portions of the work.
• Indirect costs, or overhead, are costs not tied to a single contract but necessary for operations and reasonably assigned to the project, such as equipment depreciation and insurance.

Measuring Progress and Recognizing Revenue

Once a company determines that revenue should be recognized over time and has its initial estimates, it must select a method to measure progress. Accounting standards permit two primary approaches for this: output methods and input methods.

Output methods recognize revenue based on direct measurements of the value transferred to the customer, such as milestones achieved or units produced. These methods are a direct reflection of value transfer but can be difficult to apply if the outputs are not discrete or easily measurable.

Input methods recognize revenue based on the company’s efforts or inputs, such as costs incurred or labor hours expended. The most widely used input method is the cost-to-cost method, which measures progress based on the proportion of costs incurred to date relative to the total estimated costs of the contract. This method is popular because cost information is available and provides a consistent basis for measurement.

To apply the cost-to-cost method, a company follows a specific formula. First, it determines the percentage of completion by dividing the total costs incurred to date by the most recent estimate of total contract costs. This percentage represents the portion of the project considered complete.

Next, this percentage is multiplied by the total estimated contract revenue to determine the cumulative revenue to be recognized. To find the revenue for the current period, the company subtracts the total revenue recognized in all prior periods. For instance, a project with $1,000,000 in estimated revenue and $800,000 in estimated costs that has incurred $200,000 in costs is 25% complete ($200,000 / $800,000). The cumulative revenue is $250,000 (25% of $1,000,000), which is the revenue for year one.

Accounting for Changes in Estimates and Contract Losses

Initial estimates of revenue and costs will likely change over a project’s life due to shifting market conditions or unexpected challenges. When a company revises its estimate of total contract revenue or costs, the change is accounted for using a “cumulative catch-up adjustment.”

This approach requires the company to update its measure of progress and revenue in the period the change is made. The adjustment’s entire effect is reflected in the current period’s income statement, bringing the total recognized revenue to date in line with what it would have been if the new estimate had been used from the beginning.

For example, a contract has $1 million in revenue and an initial cost estimate of $800,000. In year one, $400,000 of costs are incurred, leading to 50% completion and $500,000 of recognized revenue. In year two, the total cost estimate is revised to $850,000, and an additional $225,000 in costs are incurred, bringing total costs to date to $625,000. The new completion percentage is 73.5% ($625,000 / $850,000), and cumulative revenue should be $735,000. The revenue for year two is $235,000 ($735,000 cumulative minus $500,000 from year one).

A more severe situation arises when a contract is projected to be unprofitable. If the revised total estimated costs exceed the total estimated revenue, an overall loss is anticipated. Accounting standards require that this entire expected loss must be recognized immediately, regardless of the project’s stage of completion.

Financial Statement Presentation and Disclosures

The accounting for long-term contracts impacts how a company’s financial position and performance are reported. Specific accounts on the balance sheet and detailed notes in the financial statements are required for transparency.

Financial Statement Presentation

On the balance sheet, timing differences between work performed, billings, and cash received create unique accounts. A “contract asset” is recognized when a company has performed work and has a right to payment that is conditional on something other than the passage of time. A “contract liability” is recognized when a company has billed or received payment before the related work has been performed, often called deferred revenue.

These balances are determined on a contract-by-contract basis. If cumulative costs plus recognized profits exceed cumulative billings, the net amount is a contract asset. If billings exceed costs and recognized profits, the net amount is a contract liability. An unconditional right to payment is classified separately as a receivable.

Required Disclosures

To give financial statement users a clear understanding of a company’s long-term contracts, ASC 606 mandates extensive disclosures. These disclosures provide insight into the nature, amount, timing, and uncertainty of revenue and cash flows from customer contracts.

• Companies must disclose the methods used to recognize revenue over time and explain how they measure progress.
• They must provide detailed information about performance obligations, including the nature of the goods or services and when they are satisfied.
• The opening and closing balances of contract assets, contract liabilities, and receivables must be disclosed to help users understand changes in these accounts.
• Significant judgments made in applying the revenue guidance, such as those related to estimating variable consideration, must also be explained.