Long Term Construction Contracts

These lectures cover CPA practice questions covering  long term contracts including percentage of completion method and completed contract method.

Long Term Construction Contracts

Long term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. Examples of long-term contracts are construction-type contracts, development of military and commercial aircraft, weapons-delivery systems, and space exploration hardware. When the project consists of separable units, such as a group of buildings or miles of roadway, contract provisions may provide for delivery in installments. In that case, the seller would bill the buyer and transfer title at stated stages of completion, such as the completion of each building unit or every 10 miles of road. The accounting records should record sales when installments are “delivered.”

A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met:

  • 1.The customer simultaneously receives and consumes the benefits of the seller’s performance as the seller performs.
  • 2.The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced; or
  • 3.The company’s performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer. In addition to this alternative use element, at least one of the following criteria must be met:
    • (a)Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer.
    • (b)The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.

Therefore, if criterion 1, 2, or 3 is met, then a company recognizes revenue over time if it can reasonably estimate its progress toward satisfaction of the performance obligations. That is, it recognizes revenues and gross profits each period based upon the progress of the construction—referred to as the percentage of completion method. The company accumulates construction costs plus gross profit recognized to date in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process).

The rationale for using percentage-of-completion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression.

Alternatively, if the criteria for recognition over time are not met (e.g., the company does not have a right to payment for work completed to date), the company recognizes revenues and gross profit at a point in time, that is, when the contract is completed. This approach is referred to as the completed contract method. The company accumulates construction costs in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process).

Percentage of Completion Method

The percentage of completion method recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term contract. To defer recognition of these items until completion of the entire contract is to misrepresent the efforts (costs) and accomplishments (revenues) of the accounting periods during the contract. In order to apply the percentage-of-completion method, a company must have some basis or standard for measuring the progress toward completion at particular interim dates.

Measuring the Progress Toward Completion

As one practicing accountant wrote, “The big problem in applying the percentage-of-completion method … has to do with the ability to make reasonably accurate estimates of completion and the final gross profit.” Companies use various methods to determine the extent of progress toward completion. The most common are the cost-to-cost and units-of-delivery methods.

As indicated in the chapter, the objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed) track results. Neither measure is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances.

Both input and output measures have certain disadvantages. The input measure is based on an established relationship between a unit of input and productivity. If inefficiencies cause the productivity relationship to change, inaccurate measurements result. Another potential problem is front-end loading, in which significant upfront costs result in higher estimates of completion. To avoid this problem, companies should disregard some early-stage construction costs—for example, costs of uninstalled materials or costs of subcontracts not yet performed—if they do not relate to contract performance.

Similarly, output measures can produce inaccurate results if the units used are not comparable in time, effort, or cost to complete. For example, using floors (stories) completed can be deceiving. Completing the first floor of an eight-story building may require more than one-eighth the total cost because of the substructure and foundation construction.

The most popular input measure used to determine the progress toward completion is the cost-to-cost basis. Under this basis, a company like EDS measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract.