Contract accounting

What Is Contract Accounting?

Contract accounting is a specialized branch of accounting that deals with the financial recognition and reporting of long-term projects or contracts. It focuses on how businesses recognize revenue recognition and associated costs for projects that extend over multiple accounting periods, such as large construction projects, defense contracts, or complex software development. The core challenge in contract accounting is accurately matching the costs incurred and the revenue earned with the progress of the work, rather than simply when cash changes hands or when a project is fully completed. This approach is fundamental to providing a more accurate representation of a company's financial performance over the life of a long-term contract.

History and Origin

The need for specific rules in contract accounting arose from the unique nature of long-term contracts, where the completion of a project and the receipt of payment could span several years. Historically, companies might have deferred all revenue and costs until a project was entirely finished, using a method known as the completed-contract method. However, this approach could distort a company's financial picture, especially for businesses heavily involved in ongoing large projects, as it wouldn't reflect progress or profitability until the very end.

To address these issues and provide more timely and relevant financial information, accounting standards bodies developed guidance for recognizing revenue and costs as work progresses. A significant development in this area was the convergence project undertaken jointly by the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB). This collaboration led to the issuance of Accounting Standards Update (ASU) No. 2014-09, Topic 606, "Revenue from Contracts with Customers," and IFRS 15, "Revenue from Contracts with Customers," in May 2014. These new standards aimed to create a more consistent and comparable framework for revenue recognition across industries and jurisdictions, including specific provisions for long-term contracts.²

Key Takeaways

• Contract accounting dictates how revenue and costs are recognized for projects spanning multiple reporting periods.
• It typically uses methods like the percentage-of-completion method to match revenue with project progress.
• The goal is to provide a more accurate depiction of a company's financial performance over the life of a long-term contract.
• Modern standards like ASC 606 (GAAP) and IFRS 15 govern the principles of contract accounting globally.

Formula and Calculation

Contract accounting often utilizes the percentage-of-completion method to recognize revenue over the life of a contract. This method involves estimating the progress of a project and recognizing a proportionate amount of the total contract revenue and costs in each accounting period.

The calculation typically involves these steps:

1. Determine the percentage of completion: This is often calculated based on costs incurred to date compared to the total estimated costs for the project.

   $\text{Percentage of Completion} = \frac{\text{Costs Incurred to Date}}{\text{Total Estimated Project Costs}}$

2. Calculate cumulative revenue to be recognized: Multiply the total contract price by the percentage of completion.

   $\text{Cumulative Revenue} = \text{Total Contract Price} \times \text{Percentage of Completion}$

3. Calculate current period revenue: Subtract the revenue recognized in prior periods from the cumulative revenue.

   $\text{Current Period Revenue} = \text{Cumulative Revenue} - \text{Revenue Recognized in Prior Periods}$

Similarly, costs are recognized in proportion to the revenue recognized, or as incurred, depending on the specific application of the method and standard. Accurate tracking of work-in-progress (WIP) costs is crucial for this calculation.

Interpreting Contract Accounting

Interpreting financial statements prepared using contract accounting methods requires understanding that revenue and profits are often estimates based on the progress of a project, not necessarily tied to billing or cash collection. For a project accounted for using the percentage-of-completion method, the income statement will show a portion of the total contract revenue and profit each period, reflecting the work performed. On the balance sheet, accounts related to contracts, such as contract assets or contract liabilities (often referred to as deferred revenue or unbilled receivables in other contexts), will reflect the difference between recognized revenue and billings.

Analysts examine trends in recognized revenue and margins on long-term contracts to assess a company's operational efficiency and profitability over time, rather than waiting for project completion. This allows for a more continuous and informative evaluation of performance for businesses with extended project cycles.

Hypothetical Example

Consider "Bridge Builders Inc." which secures a contract to construct a bridge for a total price of $10 million. The estimated total cost for the project is $8 million, meaning an expected profit of $2 million. The project is expected to take two years.

Year 1:

• Costs incurred in Year 1: $3 million.
• Percentage of Completion = $3,000,000 (Costs Incurred) / $8,000,000 (Total Estimated Costs) = 37.5%.
• Revenue to be recognized in Year 1 = $10,000,000 (Total Contract Price) x 37.5% = $3,750,000.
• Cost of Revenue for Year 1 = $8,000,000 (Total Estimated Costs) x 37.5% = $3,000,000.
• Gross Profit for Year 1 = $3,750,000 (Revenue) - $3,000,000 (Cost of Revenue) = $750,000.

Bridge Builders Inc. would report $3,750,000 in revenue and $750,000 in gross profit on its income statement for Year 1, reflecting the progress made, even if billing and cash collection schedules differ. This contrasts with the completed-contract method, where no revenue or profit would be recognized until the bridge is finished.

Practical Applications

Contract accounting is particularly crucial for industries characterized by long-term projects and significant capital outlay. These include:

• Construction: Companies building commercial properties, infrastructure (roads, bridges), or large residential developments.
• Aerospace and Defense: Manufacturers of aircraft, spacecraft, or defense systems often operate under large, multi-year contracts.
• Software and IT Services: Projects involving custom software development, system integration, or long-term maintenance agreements.
• Engineering and Energy: Firms involved in designing and building power plants, refineries, or complex machinery.

The principles of contract accounting, particularly those derived from ASC 606 under Generally Accepted Accounting Principles (GAAP) and IFRS 15 under International Financial Reporting Standards (IFRS), guide how these companies report their financial position and performance. These standards require companies to evaluate contracts with customers, identify distinct performance obligations, determine the transaction price, allocate that price to the performance obligations, and recognize revenue when (or as) performance obligations are satisfied. For entities following U.S. GAAP, detailed guidance is available from the Financial Accounting Standards Board (FASB). Similarly, the International Accounting Standards Board (IASB) provides comprehensive information on IFRS 15 for global application. This consistent framework enhances the comparability of financial statements across different entities.

Limitations and Criticisms

Despite its benefits for reflecting ongoing progress, contract accounting, especially methods like percentage-of-completion, comes with limitations and criticisms. A primary concern is the reliance on estimates, which introduces subjectivity into financial reporting. Calculating the "percentage of completion" requires forecasts of total project costs and, sometimes, total revenue. These estimates can be challenging to make accurately for projects spanning years, and changes in project scope, unforeseen delays, or material cost fluctuations can necessitate significant revisions.¹

Inaccurate estimates can lead to misstated financial results, potentially overstating or understating profitability in a given period. This can create volatility in reported earnings or even lead to restatements if estimates prove significantly off the mark. While auditing aims to verify these estimates, the inherent uncertainty remains a challenge. The complexity of applying the detailed five-step model required by modern revenue recognition standards can also be burdensome for companies, requiring robust internal controls and sophisticated tracking systems.

Contract Accounting vs. Revenue Recognition

While often used interchangeably by a casual observer, "contract accounting" and "revenue recognition" are distinct but closely related concepts. Revenue recognition is a broad accounting principle that dictates when and how revenue should be recorded in a company's financial statements. It applies to all types of sales, from everyday retail transactions to complex, multi-year service agreements. The fundamental idea is that revenue is recognized when it is earned and realized or realizable, regardless of when cash flow is received.

Contract accounting, on the other hand, is a specific application of revenue recognition principles tailored for long-term contracts. It provides the detailed methodologies and rules for how revenue and associated costs are recognized for these particular types of agreements. Modern standards like ASC 606 and IFRS 15, which are fundamentally about revenue recognition from contracts with customers, effectively govern contract accounting by establishing a comprehensive framework for these complex scenarios. Therefore, contract accounting specifies the practices (like the percentage-of-completion method) used to achieve proper revenue recognition for long-duration agreements.

FAQs

Q1: What is the primary purpose of contract accounting?

A1: The primary purpose of contract accounting is to accurately match the revenue earned and the costs incurred with the progress of long-term projects or contracts over multiple accounting periods, providing a more timely and relevant view of a company's financial performance.

Q2: How does contract accounting differ from basic accrual accounting?

A2: Accrual accounting recognizes revenues when earned and expenses when incurred, regardless of cash flow. Contract accounting applies this principle specifically to long-term contracts, often requiring estimations of completion to periodically recognize revenue and costs, rather than waiting for project completion or payment.

Q3: What are the two main methods used in contract accounting?

A3: The two main methods historically discussed in contract accounting are the percentage-of-completion method and the completed-contract method. The percentage-of-completion method is generally preferred under modern accounting standards (like ASC 606 and IFRS 15) for most long-term contracts as it provides a better depiction of ongoing performance.

Q4: Why is estimation a challenge in contract accounting?

A4: Estimation is a challenge because long-term projects are inherently uncertain. Predicting total costs and the exact progress of a project years in advance can be difficult, and changes or unforeseen issues can require frequent adjustments to recognized revenue and profit. These estimates can impact the accuracy of financial statements.

Q5: Which industries commonly use contract accounting?

A5: Industries that commonly use contract accounting include construction, aerospace, defense, complex software development, and large-scale engineering projects, due to the extended duration and complex nature of their service agreements and sales.