## Long-term contracts: Introduction (LOS 7.24b and c)

Definition: A long-term contract is a contract spanning a number of accounting periods.

Accounting issue: Should we recognize the revenue over the life of the contract or at the end of the contract, since it may be difficult to establish whether the earnings process is complete.

Accounting treatment

• If the contract outcome can be measured reliably

Use the percentage-of-completion method (under both IFRS and US GAAP) under which net income is reported in the income statement as work is performed, i.e. at any reporting date estimate the percentage of the contract that has been completed, calculate revenue and expenses based on that percentage completion, and report those figures in the income statement.

• If the contract outcome cannot be measured reliably

Under IFRS, revenue is only reported to the extent of the contract costs incurred; hence no profit is recognized until the end of the contract.

Under US GAAP, use the completed contract method, i.e. do not report any revenue or cos until the contract is completed.

• If a loss is expected

Report the loss immediately regardless of the method used.

## Long-term contracts: example (LOS 7.24b and c)

### Example

Tudor Technology Inc. is building an IT network for a government department. The contract is worth \$10m and the network will take three years to complete. At the end of Year 1 \$3m has been spent, with a total expected cost of \$6m for the whole project. At the end of Year 2, a further \$2.4m has been spent with outstanding completion costs estimated at \$0.6m, i.e. total forecast costs remain at \$6m at the end of Year 2. At the end of Year 3 total spending amounted to \$6.1m on the project.

What would be shown in the income statement for each of the three years under:

a)      The percentage-of-completion method (IFRS and US GAAP)?

b)      IFRS GAAP if the contract outcome cannot be measured reliably?

c)       The US GAAP completed contract methods?

### Solution

a)       Percentage-of-completion method

Revenue and costs are based on the percentage completion, which is typically based on the expenditure incurred against total estimated project costs.

b)      IFRS GAAP if the contract outcome cannot be measured reliably

Revenue is only reported to the extent of the contract costs incurred, hence no profit is recognized until the end of the contract.

c)       US GAAP completed contract methods

Do not report any revenue or costs until the contract is completed.

## Long-term contracts: comparison of methods (7.24b and c)

The percentage-of-completion method results in earlier revenue recognition than either other method, however it is a less conservative approach that:

• Relies on management estimates of the future cost, hence stage of completion

• Not as objective as the completed contract method

• Results in better matching of revenues and costs with the period in which they are earned

## Installment sales: introduction (LOS 7.24b and c)

Definition: Sales in which the proceeds are to be paid in installments over an extended period.

Recognition of revenue or profit may need to be deferred where there are doubts about the continuing involvement of the seller or the buyer’s willingness and/or ability to pay.

US GAAP methods:

• Installment method: The profit recognized is determined by the percentage of the cash consideration received.

• Cost recovery method: No profit is recorded until the cash received exceeds costs.

Both treatments are rare.

## Installment sales: example – installment method (LOS 7.24b and c)

### Example

Plantagenet Property Inc. has agreed to sell for \$4m a property that cost them \$3m. A down payment of \$400,000 is made in Year 1 with the balance paid in equal annual installments over the next nine years, i.e. ten years in total. What profit will be shown over each of the next ten years where the seller uses the installment method?

### Solution

Each year, the cost and profit recognized is determined by the percentage of the cash consideration received. As 10% (\$400,000/\$4,000,000) of the total revenue is received and recognized as revenue each year, 10% of the costs (\$3m × 10% = \$300,000) and 10% of the profit ((\$4m –\$3m) – 10% = \$100,000) are also recognized each year.

## Installment sales: example – cost recovery method (LOS 7.24b and c)

Example

Plantagenet Property Inc. has agreed to sell for \$4m a property that cost them \$3m. A down payment of \$400,000 is made in Year 1 with the balance paid in equal annual installments over the next nine years, i.e. ten years in total. What profit will be shown over each of the next ten years where the seller uses the cost recovery method?

### Solution

Each year, the cost recognized is determined by the percentage of the cash consideration received, however no profit is recorded until the cash received exceeds the total costs. Hence, as 10% (\$400,000/\$4,000,000) of the total revenue is received each year, 10% of the total costs (\$3m × 10% = \$300,000) is recognized each year, although no profit is recorded until Year 8 when the total cash receipts first exceed the total cost of \$3m.

Of the \$400,000 received in each of the first seven years, \$300,000 is regarded as revenue (so that no profit is recognized) and \$100,000 is treated as unearned revenue, hence there is \$700,000 of accumulated unearned revenue by the end of Year 7.

In Year 8, accumulated cash receipts reach \$3.2 million hence, against a total cost of \$3 million, a profit of \$200,000 needs to be recognized by recognizing \$500,000 of revenue against the \$300,000 cost recognized for the year, the revenue being the \$400,000 cash received plus \$100,000 from the accumulated unearned revenue.

In Years 9 and 10, we need to recognize \$400,000 of profit each year as all of the cash receipts now exceed the original cost. This is achieved by recognizing \$700,000 of revenue against the \$300,000 cost recognized for the year, the revenue being the \$400,000 cash received plus \$300,000 from the accumulated unearned revenue in each of these last two years.

## Barter transaction (LOS 7.24b and c)

By the end of Year 10, all revenue, costs and profits have been recognized and there is no remaining accumulated unearned revenue.

Definition: Transactions where companies transfer goods or services in return for other goods/services, e.g. exchanges of advertising space on websites.

Accounting treatment

• IFRS: Recognize revenue based on the fair value of the revenue from similar non-barter transactions with unrelated parties.

• FASB: Revenue can be recognized based on the fair value only if the company has historically received cash payments for the goods or services.

## Gross vs net reporting (LOS 7.24b and c)

Accounting issue: The issue arises where goods are shipped by an intermediary from a supplier straight to a customer, the intermediary never having any involvement other than facilitating the transaction. For example, an intermediary buys goods for \$100 and sells them on for \$110 incurring costs of \$4. They have clearly made a profit of \$6 but should they recognize turnover of \$110 and costs of \$104 (gross reporting) or turnover of \$10 and costs or \$4 (net reporting)?

Accounting treatment: To be able to report gross revenues, the intermediary company must:

• Be primary obligor

• Bear inventory and credit risk

• Be able to choose suppliers and have latitude to determine their own selling price

## Revenue Recognition Accounting Standards Issued May 2014 (LOS 7.24d)

Converged accounting standards issued by the IASB and FASB in May 2014 introduced some basic changes to the principles of revenue recognition designed to enhance comparability. The standards were effective from 1 January 2017 under IFRS and 15 December 2016 under US GAAP.

The core principle of the converged standard is that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which entity expects to be entitled in an exchange for those goods or services.

The standard applies five steps in recognizing revenue:

1. Identify the contract(s) with a customer

2. Identify the performance obligations in the contract

3. Determine the transaction price

4. Allocate the transaction price to the performance obligations in the contract

5. Recognize revenue when (or as) the entity satisfies the performance obligation

## Exam focus

Reading 24 lays out the criteria for revenue recognition under US GAAP and IFRS. You should learn these in case you get a direct knowledge question asking you to recall them. However, it is likely to be more important to focus on the special instances of revenue recognition and to be able to outline the accounting treatment for these transactions. At first glance, it looks like the criteria are different between the two accounting codes, however, the criteria are very similar—the IFRS criteria is just worded more formally. One criteria that is missing from both sets of criteria is the need for cash to have been received to be able to recognize revenue. This criteria is not required by either accounting code and is the key concept underpinning revenue recognition.

It is important to work through the revenue examples within Reading 24 since this will allow you to calculate the revenue to be recognized under each of the transactions shown, although it is unlikely that the exam questions will follow the exact format of the examples in the readings. It is much more likely that you will have to deal with a different scenario and apply your knowledge. Remember, the key principle of accrual accounting is the ability to recognize revenue independently of cash collection. This is the same for both US GAAP and IFRS.

The Study Guides and other exam prep information available on Investopedia are for informational purposes only. Exam content review, methods of study, tips and sample questions are only recommendations, and use of this material does not guarantee passing any exam.

Income Statement: Expense Recognition

Related Articles
1. Investing

### Don't Lose Your Shirt On Mutual Fund Sales

Mutual funds aren't guaranteed profit-makers, but with the right calculations and timing, you can avoid major losses.
2. Investing

### The Importance Of Analyzing Accounts Receivable

While investors often focus on revenues, net income, and earnings per share, they should not overlook the importance of analyzing accounts receivable.
3. Investing

### Why GAAP and Non-GAAP Are More Divergent Since 2009

Examine the divergence of GAAP and adjusted earnings in the years leading up to 2015 to identify the factors causing the gap to widen.

### The Difference Between Forwards and Futures

Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
5. Tech

### 10 Public Companies That Rely On Govt. Contracts

We look at 10 of the top public companies whose businesses rely on U.S. government contracts.
6. Personal Finance

### Alternate Methods Of Online Payment

Paying by credit is one of the most common methods of payment for online shopping in the U.S. However, there are many other options worth testing out.