Long term construction contracts

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1. Accounting issue

The accounting issue is one of revenue recognition

1.1   Authoritative Pronouncement

ARB 45 – long term construction type contracts

SOP 81-1 – long term construction type contracts

1.2   Illustration

A company enters into a contract to construct a football stadium. The contract iw worth $200 million dollars and will last for three years. The expected costs have been estimated as follows:

Year 1                                   $80 million

Year 2                                   $60 million

Year 3                                   $40 million

Overall estimated profit $20 million

The question is whether to recognise any profit and revenue only when the contract is completed and the stadium is delivered? This would be prudent but would not reflect the earnings of the business in the income statement.

Alternatively the profit could be allocated, together with a proportion of revenue, to each of the three years of the project. This could be match income-to-income earning activities but would it be prudent?

1.3   Definition

There is no formal definition of a qualifying long-term contract within US GAAP but this treatment may apply to contracts where

(a)    Gross profit is taken on a % complete basis

(b)   Inventories and receivables are material and the contract duration is expected to be more than 12 months

(c)    Ownership effectively passes to the customer throughout the course of the contract

2. Completed contract method

For those contracts when the future costs cannot be reliably estimated or if the contract is anticipated to be loss making

    2.1 Accounting treatment

Direct costs and overheads are booked to a construction-in-progress account (asset)

Billings are charged to a billings in advance account (liability)

Individual contract balances should be netted off at the balance sheet date

At completion the total costs and income and transferred to net income

2.2  expected losses

These should be recognize in full over the duration of the contract. The loss should be recorded in net income and deducted from the construction-in-progress account.

3. Percentage of completion method

This method should be used for those contracts which are profitable and for which

amounts of future costs can be reliably estimated.

3.1 Accounting treatment

In addition to the recognition of costs as for completed contracts method, each year an

amount of gross profit should be added to the construction asset.

This profit may be calculated either as a percentage of costs incurred to date, by the

value of certified work compared to the total contract value or some other reasonable

basis.

3.2 Losses on contracts

The percentage complete method is not available for loss making contracts. In addition

any losses on contracts should be recognized at the point of recognition. You will also

need to cancel any profits previously recognized.

3.3 Illustration

Able Inc has entered into a fixed price contract worth $10m. The estimated costs of the

contract are as follows:

Year     1            2          3

Costs   2,000,000   5,000,000    1,000,000

The contract qualifies to be accounted for on a percentage of completion basis as

follows: 

Year 1

Revenue recognized based on cost incurred

$

$ 2 , 000 , 000

$10m x

2,500,000

$ 8 , 000 , 000

Costs incurred                                              (2,000,000)

Gross profit                                                    500,000

Construction in progress asset

$(2,000,000 + 500,000)                                      2,500,000

In year 2 costs are as estimated

Revenue earned to date:

$7 , 000 , 000  x $10,000,000 =        8,750,000

                   $ 8 , 000 , 000

Less recognised in year 1                                   (2,500,000)

Year 2 revenue                                                   6,250,000

Cost incurred                                                       5,000,000

Gross profit                                                         1,250,000  

Construction in progress asset                              8,750,000

$(2,000,000 + 500,000 + 5,000,000 + 1,250,000)

The above presumes that no invoices are raised on account of work completed.

In year 3 now suppose that actual costs come to $2,000,000 with a further $2,000,000

required in year 4 when the contract will be completed.

In this situation the contract is now loss making.

Revenue (as before)                                   10,000,000

Cost year    1          2000,000

                  2          5000,000

                 3           2000,000

Estimated 

Year           4           2000,000                     (11,000,000)

Anticipate loss recognized immediately        (1000,000)

The profit taken to date must also be cancelled

Profit taken 

Year         1             500,000

                2             1250,000

                                                                  (1750,000)

Gross loss recognized in year 3                     (2750,000)

The balance sheet asset will then be restated

Balance brought forward                                8750,000

Add costs incurred                                          2000,000

                                                                    10,750,000

 Less loss provision                                         (2750,000)

Construction in progress asset                         8,000,000

Year 4 -- contract completed

Construction in progress asset b/fwd                 8000,000

Add costs incurred                                           2000,000

                                                                    10,000,000

Less invoiced contract value                           (10,000,000) 

Closing balance                                                -----