How to Recognize Revenue from Long-Term Contracts?

Posted In | Finance | Accounting Software | Revenue Recognition

Long-term contracts, such as those commonly found in the construction, engineering, and software development industries, can present unique challenges in revenue recognition. Companies must determine when and how to recognize revenue from these contracts, ensuring compliance with established accounting standards and accurately reflecting their financial performance. This article will provide a comprehensive guide on how to recognize revenue from long-term contracts, considering the applicable accounting standards, methods, and best practices.

 

Understanding the Applicable Accounting Standards

Companies must familiarize themselves with the relevant accounting standards that govern revenue recognition for long-term contracts, such as ASC 606 in the United States and IFRS 15 internationally. These standards provide a comprehensive framework for recognizing revenue from contracts with customers, offering specific guidance for long-term contracts. Familiarity with these standards is essential for accurate financial reporting and regulatory compliance.
 

Methods for Revenue Recognition in Long-Term Contracts
 

1. Percentage-of-Completion Method

The percentage-of-completion method recognizes revenue based on the proportion of work completed at the reporting date. This method requires businesses to estimate the extent of work completed, which can be based on costs incurred, milestones achieved, or other measures of progress.
 

Pros:

• Suitability: Ideal for long-term contracts where progress can be reasonably estimated and measured.
   

• Reflects economic reality: Provides a more accurate representation of a company's financial performance, as it matches revenue with the actual provision of goods or services.
   

Cons:

• Estimation uncertainty: Requires subjective estimates of work completed, which can be prone to error.
   

• Potential for manipulation: Creates opportunities for earnings management, as companies can manipulate the percentage of work completed to influence reported revenue.

 

2. Completed-Contract Method

The completed-contract method recognizes revenue only upon the completion of the entire contract. This method is generally used when the outcome of a long-term contract is uncertain, or when accurate estimates of progress are difficult to obtain.
 

Pros:

• Reduced estimation uncertainty: Eliminates the need for subjective estimates of work completed, as revenue is recognized only upon contract completion.
   

• Suitability: Appropriate for long-term contracts with uncertain outcomes or where accurate estimates of progress are challenging to obtain.
   

Cons:

• Delayed revenue recognition: Can result in a delay in revenue recognition, which may not accurately reflect a company's financial performance during the reporting period.
   

• Potential cash flow issues: May create cash flow challenges for businesses, as revenue is recognized only upon contract completion, even if payments are received during the project.
   

Best Practices for Recognizing Revenue from Long-Term Contracts
 

1. Accurately estimate project costs and progress: Companies should develop reliable methods for estimating project costs and progress, as these estimates directly impact revenue recognition. Regularly reviewing and updating these estimates can help ensure accuracy and minimize errors.
 

2. Establish clear revenue recognition policies and procedures: To ensure consistent application of revenue recognition principles, companies should establish clear policies and procedures that outline the specific steps and criteria to be followed in recognizing revenue from long-term contracts.
 

3. Implement robust internal controls: Companies should implement robust internal controls to ensure the accuracy and reliability of their revenue recognition processes, including controls related to the estimation of project costs and progress, the timing of revenue recognition, and the recognition of contract costs.
 

4. Train and educate finance and accounting personnel: Companies must invest in ongoing education and training for their finance and accounting personnel to ensure they are well-versed in the latest revenue recognition standards and best practices for long-term contracts.
 

5. Seek professional advice: Given the complexity of revenue recognition for long-term contracts, companies may benefit from seeking professional advice from accountants or financial advisors who specialize in this area. These professionals can provide valuable insights and guidance, helping businesses navigate the intricacies of revenue recognition and maintain regulatory compliance.
 

6. Maintain thorough documentation: Companies should maintain thorough documentation of all aspects of their long-term contracts, including contract terms, performance obligations, project costs, progress, and revenue recognition decisions. This documentation can help support the company's financial reporting and provide a basis for any necessary adjustments or revisions.
 

7. Monitor contract performance: Regularly monitoring the performance of long-term contracts can help companies identify potential issues and make informed decisions about revenue recognition. This may involve tracking project milestones, analyzing cost variances, and assessing the likelihood of contract modifications or disputes.
 

8. Communicate with stakeholders: Transparent communication with stakeholders, such as investors, auditors, and regulatory authorities, is crucial for building trust and demonstrating compliance with revenue recognition standards. Companies should be prepared to explain their revenue recognition policies, procedures, and judgments, and provide detailed disclosures in their financial statements.


Recognizing revenue from long-term contracts can be a complex and challenging process, requiring companies to navigate the intricacies of accounting standards, choose appropriate methods, and implement robust controls and procedures. By following best practices, such as accurately estimating project costs and progress, establishing clear policies and procedures, investing in staff training and education, and seeking professional advice, companies can effectively recognize revenue from long-term contracts, ensuring accurate financial reporting and maintaining regulatory compliance. This, in turn, will help build trust with investors and stakeholders, ultimately contributing to the company's long-term success.