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The five step revenue recognition process also applies to long-term contracts. Important notes below.
Step 2 (Identify the performance obligation(s) in the contract): Most long-term contracts should be viewed as including a single performance obligation. Remember the house example?
Step 5 (Recognize revenue when (or as) each performance obligation is satisfied): Most long-term contracts qualify for revenue recognition over time. Why? Imagine if the construction companies that built Citizen's Bank Park and Lincoln Financial Field weren't able to recognize any revenue until the stadiums were complete. In such a case, the owners' of the construction companies would not have received an accurate representation of the companies' operations while the construction projects were in progress.
Accounting for a profitable long-term contract
Accounting for a profitable long-term contract
The same total amount of revenue is recognized whether it's over the term of the contract or only upon completion, but the timing of recognition differs. [01]
Recognizing revenue over time using the percentage of completion method
Recognizing revenue over time using the percentage of completion method
Revenue recognized this period = {Total estimated revenue Ă— percentage completed to date} - revenue recognized in prior periods
Recognizing revenue at the completion of the contract
Recognizing revenue at the completion of the contract
Regardless of whether revenue is recognized upon completion or over time, at contract completion, the construction balance sheet accounts - construction in progress and billings on construction contract - need to be zeroed out. You can see this in the example below.
A comparison of revenue recognized over the term of the contract and at the completion of the contract
A comparison of revenue recognized over the term of the contract and at the completion of the contract
Long-term contract losses
Long-term contract losses
If, during the construction project, estimates of cost change and the project flips from being a profitable project to a project that will generate a loss, does anything change in our accounting entries?
Suppose the contract value is $5,000,000 and in year 2 of construction, new, updated cost estimates indicate that you are no longer going to be able to make a profit. The entire project is going to lose money. You started out with an estimated total cost of $3,750,000 and in year 2, the estimate has expanded to $5,100,000. If this happens, you need to record THE ENTIRE ESTIMATED LOSS FOR THE ENTIRE PROJECT at the point in time when the new estimates become available. Uh oh. This is true regardless of whether revenue is being recognized upon completion or over the life of the contract.
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