When Is a Loss Recognized on a Long-Term Contract?

Long-term contracts are agreements for projects that span multiple accounting periods, often seen in industries like construction, defense, or software development. These contracts involve significant revenue and cost recognition challenges due to their extended timelines. Accounting for such projects requires careful estimation of future costs and revenues. Sometimes, these estimations reveal that a contract may ultimately result in a financial loss rather than a profit. When such a situation arises, specific accounting rules dictate when and how these losses must be recognized in a company’s financial statements.

Identifying a Loss on a Long-Term Contract

A loss on a long-term contract, often referred to as an “onerous contract” or a “foreseeable loss,” is identified when the total estimated costs to complete the project are expected to exceed the total estimated revenues from that contract. An onerous contract is one where the unavoidable costs of meeting the obligations under the contract are greater than the economic benefits expected to be received. This determination requires continuous and careful forecasting throughout the contract’s life. The assessment of whether a contract is onerous involves comparing the total estimated costs, including all direct costs like labor, materials, and allocated overheads, with the total expected revenue. For instance, if unexpected material price increases or project delays occur, a previously profitable contract might become onerous.

Loss Recognition Under the Percentage-of-Completion Method

When a company uses the percentage-of-completion method, revenues and expenses are recognized proportionally as work progresses on the contract. However, the rule for loss recognition differs significantly from profit recognition. If at any point it becomes evident that the entire contract will result in a loss, the full anticipated loss must be recognized immediately in the period it becomes probable and estimable, regardless of the project’s percentage of completion. For example, if a contract was initially projected to generate a profit but updated estimates indicate an overall loss of $50,000, this entire $50,000 loss must be recorded as an expense in the current period. This approach ensures that financial statements promptly reflect the economic reality of the contract’s downturn, providing financial statement users with timely information about potential problems.

Loss Recognition Under the Completed-Contract Method

The completed-contract method defers the recognition of all revenues and profits until the project is entirely finished. Despite this deferral for revenue and profit, any anticipated loss on the entire contract must still be recognized immediately, as soon as it becomes probable that total estimated costs will exceed total estimated revenues. This aligns with the conservative accounting principle of recognizing losses as soon as they are known, while delaying profit recognition until certainty. This means that even if a contract is only partially complete and no revenue or profit has yet been formally recognized, a company must book the entire expected loss as soon as it is identified. This immediate recognition provides transparency to financial statement users, informing them of potential financial burdens without waiting for project completion.

Adjusting for Changes in Estimates

Long-term contracts are dynamic, and initial cost and revenue estimates frequently change over time due to various factors like unforeseen challenges or shifts in material prices. When revisions indicate that a contract initially projected a profit will now result in an overall loss, that loss must be recognized immediately in the period the change occurs, irrespective of the accounting method used. Conversely, if a contract was initially expected to result in a loss, but improved estimates later reduce or eliminate that anticipated loss, adjustments are made in the period the estimate changes. These adjustments are forward-looking, impacting the current and future financial statements by reducing or reversing the previously recognized loss provision. Companies must continuously monitor their contracts, identify potential losses, and update their estimates regularly to ensure accurate and reliable financial reporting.