Revenue Recognition Construction-Type and Production –Type Contracts ASC 605-35 Selected Highlights

Overview This subtopic provides guidance on accounting for the performance of contracts for the construction of facilities or production of goods or related services according to customer specifications. Problems arise particularly in connection with long-term contracts. Two methods are commonly followed: percentage-of-completion and completed-contract methods. Both methods involve estimates and uncertainties in three key areas: The extent of completion Contract revenues Contract costs

Scope Applies to all contractors Applies to contracts: Specifications are provided by the customer For the construction of facilities or production of goods or the provision of related services. Four broad types of contracts: Fixed price Cost-plus (cost-type) Time-and-material Unit-price

Recognition Determining accounting policy: Percentage-of-completion or completed-contract Two methods are not acceptable alternatives for the same circumstances Determining the profit center Assume each contract is a profit center Overcome this assumption if contracts meet the conditions for combining or segmenting contracts

Combining contracts Group of contracts that are closely related and are in effect parts of a single project. Report revenue and profit uniformly over the performance of the combined contracts. Criteria for combining: Negotiated as a package For a single project Closely interrelated construction activities with substanial common costs Performed concurrently or in a continuous sequence – same project management and location With a single customer

Segmenting contracts Includes elements or phases negotiated separately to perform without regard to the performance of others Segment if specified steps were taken and are documented and verifiable. Major factors that must be considered in determining total estimated revenue include: Basic contract price Contract options Change orders Claims Contract provisions for penalties and incentive payments

Provisions for losses on contracts Cost elements to be identified, estimated and accumulated with a reasonable degree of accuracy: Costs incurred to date Estimated costs to complete Provisions for losses on contracts If a loss is anticipated, GAAP requires recognition of the entire anticipated loss as soon as the loss becomees evident. This is true for both the percentage-of-completion and completed-contract methods.

Percentage-of-completion method Recognized income as work on a contract progresses May be estimated total income: based on total incurred costs to date relative to estimated total costs Or some other measure of progress towadr completion of work performed Units of delivery method is a modification of the percentage-of-completion method recognize as revenue the contract price of units delivered during a period Percentage-of-completion is appropriate if there is the ability to make reasonably dependable estimates of progress toward completion, contract revenues and contract costs.

In addition to the ability to make reasonably dependable estimates, all of the following conditions must exist: Contracts specify enforceable rights regarding goods/services to be provided, consideration to be exchanged, and the manner and terms of settlement Both the buyer and contractor can be expected to satisfy all obligations. An entity using the percentage-of-completion method as its basic accounting policy should use completed-contract method for a single contract (or group of contracts) if it cannot make reasonably dependable estimates.

Zero profit margin approach to applying the percentage-of-completion method Recommended for a situation where there is assurance that no loss will be incurred on a contract scope of the contract is ill-defined, but the contractor is protected by a cost-plus contract. Equal amounts of revenue and costs are presented on the income statement. A change to a more precise estimate of profit is a change in accounting estimate.

Completed-contract method Income is recognized only when a contract is completed or substantially completed. Provision is made for any expected losses. Use the completed contract method when there is a lack of dependable estimates or inherent hazards cause forecast to be doubtful. An entity may use the completed contract method for circumstances in which the financial statements would not vary materially from those resulting from use of the percentage-of-completion method (primarily short-term contracts).

Presentation Percentage-of-completion Completed-contract Assets = costs and recognized income not yet billed Liabilities= billings in excess of costs and recognized income Completed-contract Excess of accumulated costs over related billings is a current asset Accumulated billings over related costs is a liability