What Are the Long-Term Contract Methods of Accounting?
Understand the principles for recognizing revenue on multi-year projects and how the chosen accounting method impacts financial reporting and tax compliance.
A long-term contract is an agreement for goods or services not completed within the fiscal year it began. These are common in industries like construction and aerospace, where projects span multiple years. Standard accounting, which recognizes revenue at the point of sale, does not work well for these projects.
It can create misleading financial statements that show years of costs with no revenue, followed by a large revenue influx upon completion. To address this, specialized accounting methods were developed to align revenue recognition with the costs incurred throughout the project’s life, providing a more accurate view of a company’s performance each year.
Available Accounting Methods for Long-Term Contracts
U.S. Generally Accepted Accounting Principles (GAAP), under Accounting Standards Codification (ASC) Topic 606, provide a model for long-term contracts based on when control of goods or services transfers to a customer. This requires companies to determine if revenue should be recognized “over time” or at a “point in time.”
Recognizing revenue over time means revenue is recorded in each accounting period as progress is made. This approach is similar to the former Percentage of Completion Method and requires reliable estimates of project progress.
If the criteria for over-time recognition are not met, revenue is recognized at a single point in time when the project is complete and control transfers to the customer. This method, similar to the former Completed Contract Method, defers all revenue and profit until the final year.
Determining the Appropriate Method
The choice of revenue recognition method is guided by separate rules for financial reporting and tax purposes.
For financial statements under U.S. GAAP, revenue must be recognized over time if the customer receives benefits as work is performed, the work enhances an asset the customer controls, or the work creates an asset with no alternative use to the company and the company can demand payment for work done. If none of these criteria are met, revenue is recognized at a point in time.
For income tax purposes, the Internal Revenue Code mandates a percentage of completion method for most long-term contracts. However, there are exceptions. The “small construction contractor” exemption allows use of the completed contract method if average annual gross receipts for the prior three years do not exceed $31 million for 2025 and the contract is expected to finish within two years.
Another exception is for “home construction contracts,” where at least 80% of total estimated costs relate to building or improving dwelling units in a building with four or fewer units.
Applying the “Over Time” Recognition Method
When recognizing revenue over time, companies must measure their progress to determine the revenue for each period. A common approach is the cost-to-cost method, which uses the total contract price, total estimated costs, and actual costs incurred to date.
The first step is to calculate the percentage of completion using the formula: Percentage Complete = Costs Incurred to Date / Total Estimated Costs. For a project with $300,000 in costs incurred and $1,000,000 in total estimated costs, the project is 30% complete.
Next, calculate the cumulative revenue to be recognized: Cumulative Revenue = Total Contract Price x Percentage Complete. If the contract price is $1,200,000, the cumulative revenue is $360,000 ($1,200,000 x 30%).
To find the current period’s revenue, subtract any revenue recognized in prior periods. If $150,000 was recognized previously, the current period’s revenue is $210,000 ($360,000 – $150,000). The costs incurred in the current period are then expensed against this revenue to find the gross profit.
If total estimated costs change, the calculation must be updated in current and future periods. If at any point total estimated costs exceed the total contract price, an anticipated loss exists. GAAP requires that the entire expected loss on the contract must be recognized immediately in the period it is identified.
Financial Statement Presentation
Long-term contract accounting creates specific accounts on the balance sheet to manage timing differences between work, billing, and revenue recognition. These are classified as current assets or liabilities.
A “Contract Asset” is recognized on the balance sheet when a company has recognized more revenue than it has billed the customer. This asset signifies that the company’s work is ahead of its billing schedule and arises when revenue recognized exceeds amounts billed.
A “Contract Liability” is recognized when billings to the customer exceed the revenue recognized to date. This liability represents an obligation for the company to perform more work in the future.
On the income statement, the revenue calculated for the period is reported, often as “Revenue from long-term contracts.” The associated costs are reported as “Cost of earned revenue,” separating the results of long-term projects from other business activities.