Revenue Recognition and Long-Term Contracts

Revenue Recognition and Long-Term Contracts

The latest revenue recognition standards, Topic 606- Revenue from Contracts with Customers (ASU 2014-09), have prompted important changes to the accounting for long-term contracts. Topic 606 supersedes the old guidance provided by Topic 605, which had prescribed the use of the completed contract method or, more commonly, the percentage-of-completion method. The new guidance for long-term contracts requires firms to divide a contract into separate performance obligations, assigning a transaction price to each based upon its observed or estimated standalone selling price at contract inception, and to determine when the customer has control of the contracted good or service. Contractors should, generally, recognize revenue “over time” (incrementally during the life of the contract) when the customer has control. Alternatively, when contractors retain control, they should recognize revenue at “a point in time” when control is eventually transferred to the customer.

We present a hypothetical example to demonstrate the accounting techniques for a long-term contract under both the old (Topic 605) and new (Topic 606) revenue guidance. As our example shows, the determination of control and of separate performance obligations, along with the assignment of transaction prices to each, can have a dramatic effect on the timing of revenue, expense, and profit recognition under the new revenue standards. All else equal, the sooner that a customer is deemed to have control over a good or service, the sooner the revenue and expense will be recognized. Also, all else equal, the sooner that the higher-profit-margin work is performed relative to the lower-profit-margin work, the sooner that profit will be recognized.

Topic 606 helps to clarify the principles for recognizing revenue for long-term contracts and other transactions. Based upon the structure of a long-term contract, the reported financial performance across time periods can differ dramatically under the old and new revenue recognition standards. Topic 606 gives managers more discretion with respect to revenue and cost recognition across time periods than they had with the traditional percentage-of-completion or completed contract methods which may result in more accurate and nuanced financial reporting relative to that under the old Topic 605. Given the central role that revenue recognition plays in reported financial performance, we suggest that both financial statement preparers and users benefit from a clear understanding of the effects of the new  Topic 606 on long-term contracts.