An example of recognising revenue from long-term contracts

Revenue recognition of long-term contracts

Normally revenue under service and construction contracts is recognized in proportion to performance, e.g., time basis, milestones, percent of work completed. Here percent of work completed as informed by achievement of specified milestones, time, or cost to cost basis might be reasonable. lFRS states says that revenue from long term contracts should only be recognised when all the following conditions are met:

1. The amount of revenue can be measured reliably
2. It is probable that the economic benefits associated with the transaction will flow to the entity
3. The stage of completion of the transaction at the end of the reporting period can be measured reliably
4. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably

First long-term contract

CYHT Tech Co is engaged in developing and installing a new major new IT system for a customer for fixed fee of $53m. The contract is expected to take 18 months to complete and expected contract costs are $2m. Under the terms of the contract:

• The customer incurs no obligation to pay for the work until CYHT Tech Co has demonstrated a working prototype of the software, at which point 50% of the total consideration is payable. If CYHT Tech Co is unable to demonstrate a working prototype within 12 months of start of contract the customer can cancel the contract without penalty.
• After initial payment, further payments are to be made as follows:
• A further 10% of consideration is due once user acceptance testing is complete.
• The next 40% of consideration is due based upon completion of delivery and installation of hardware and software.

At the end of its fiscal year, CYHT Tech Co has been working on the contract for 9 months and has just completed the working prototype and invoiced the client for $1.5m. CYHT Tech Considers that the project is 60% complete in relation to the effort and cost involved, and at year end it has incurred and paid project costs of $1.2m.

What would the results, cash flows and balance sheet of CYHT Tech Co look like at year end?

For the first contract CYHT Tech Co can recognise revenue equal to the % of work performed, in this case CYHT Tech has evaluated the work as 60% complete, so $1.8m is recognised.

CYHT Tech will also recognise costs of 60% of expected costs of $2m = $1.2m. However, the customer receivable (invoiced value) will be only 50% of $3m, $1.5m. and while no cash has yet been received, we can assume CYHT Tech has paid costs of $1.2m.

Second long-term contract

CYHT Tech has a second contract for a similarjob which started at the same time the one discussed previously, except that the client is billed in 18 equal monthly instalments.

These instalments are refundable if a working prototype is not demonstrated after 12 months, and all nine invoiced instalments are paid up at year end. At year end a working prototype has not been demonstrated. CYHT Tech considers the project is on budget and 40% complete and it has incurred and paid project costs of $0.8m.

What would the results, cash flows and balance sheet of CYHT Tech Co look like at year end for this contract?

Under the second contract, where CYHT Tech has not delivered a working prototype. CYHT Tech would need to establish whether it was probable that they will receive economic benefits and that they can reliably measure the stage of completion. A more conservative company might determine that failing to meet the first milestone means that no revenue nor profit should be recognised at this point, while a more aggressive one might recognise revenue of $1.2m.

Note that while no revenue is recognised in P&L neither are any costs. On the assumption that these will be recoverable under the contract the costs incurred are placed on the balance sheet and netted against the contract billings, which in this case create a net liability.

In the first case where no revenue is recognised the contract margin as at the yearend is nil.

The third case represents revenue recognition with uncertain outcome, here revenue is recognised but is restricted to costs incurred, so no profit margin is recognised

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