Long-Term Contract

Definition

A long-term contract refers to an agreement that extends over two or more accounting periods before completion. Such contracts typically involve the design, manufacture, or construction of substantial assets, common in industries like construction or civil engineering. A significant accounting challenge arises in determining the profit allocable to each accounting period prior to the contract’s completion.

Percentage-of-Completion Method

The percentage-of-completion method is generally used to report turnover and related activities as the contract advances. This method allows for the recognition of profit attributable to the work completed by a specific accounting date, provided that the contract’s outcomes can be assessed with reasonable certainty.

Attributable Profit

Attributable profit is the portion of the total estimated profit over the duration of the contract that can be reasonably allocated to the work performed up to a particular accounting date. This profit calculation considers estimated costs for remedial work, maintenance, and any unrecoverable costs per the contract agreement.

Relevant Standards

In the context of the UK and Republic of Ireland, construction contracts are governed by Section 23 of the Financial Reporting Standard Applicable. Internationally, IAS 18 (Revenue) and IAS 11 (Construction Contracts) are applicable standards.

Examples

Construction Projects: A two-year project to build a skyscraper is a long-term contract. The construction company would periodically recognize revenue and profit based on the percentage of the project completed.
Software Development: A multi-year contract to develop a complex software solution. The software company recognizes revenue as the work progresses to meet contract milestones.
Shipbuilding: A three-year contract to build a cruise ship. The shipyard recognizes revenue incrementally as construction stages are completed.

Frequently Asked Questions (FAQs)

What is a long-term contract in accounting? A long-term contract in accounting is a contract that spans two or more accounting periods before its completion, typically involving substantial design, manufacture, or construction activities.
How is profit determined in a long-term contract? Profit in a long-term contract is determined using the percentage-of-completion method, which allocates a part of the total contract profit to each period based on the work completed.
What is the percentage-of-completion method? This method calculates revenue and profit incrementally based on the value of work completed at specific accounting dates.
What is attributable profit? Attributable profit is the portion of total estimated profit that can be allocated to the work completed up to the accounting date, allowing for future remedial costs and unrecoverable increases in costs.
Which accounting standards apply to long-term contracts? The relevant standards include Section 23 of the Financial Reporting Standard Applicable in the UK and Republic of Ireland, IAS 18 (Revenue), and IAS 11 (Construction Contracts).

Percentage-of-Completion Method: An accounting method that recognizes revenue and profits incrementally as work on a contract progresses.
Attributable Profit: The portion of total contract profit allocated to completed work up to a specific accounting period.
Financial Reporting Standards: Guidelines and principles for the preparation of financial statements.
IAS 11 (Construction Contracts): An International Accounting Standard that provides guidance on accounting for construction contracts.
IAS 18 (Revenue): An International Accounting Standard that addresses revenue recognition principles.

Online Resources

Suggested Books for Further Studies

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
“Financial & Managerial Accounting” by Mark Bettner, Ray Whiting, and Robert Libby
“Accounting Principles” by Jerry J. Weygandt

Accounting Basics: “Long-Term Contract” Fundamentals Quiz

### What does a long-term contract typically involve? - [ ] Short-term agreements within a single fiscal year - [x] Design, manufacture, or construction spanning multiple accounting periods - [ ] Only purchasing of stock - [ ] Lease agreements for less than one year > **Explanation:** A long-term contract involves the design, manufacture, or construction of a significant asset and spans multiple accounting periods. ### What method is commonly used to recognize revenue in long-term contracts? - [ ] Cash basis - [ ] Accrual basis - [x] Percentage-of-completion method - [ ] Completed contract method > **Explanation:** The percentage-of-completion method is commonly used to recognize revenue incrementally as the contract progresses. ### When can the part of profit be recognized in a long-term contract? - [ ] Only on contract completion - [ ] As soon as costs are incurred - [x] As the work progresses and outcomes can be assessed reasonably - [ ] When the contract is cancelled > **Explanation:** Profit can be recognized as the work progresses and outcomes can be reasonably assessed. ### What is attributable profit? - [x] Profit estimated to arise over the duration of the contract after considering costs - [ ] Total profit estimated at beginning of contract - [ ] Profit without considering any costs - [ ] Only the profit made in the last accounting period > **Explanation:** Attributable profit considers the estimated total over the contract’s duration, including allowances for costs. ### Which sector commonly deals with long-term contracts? - [ ] Retail - [x] Construction - [ ] Financial services - [ ] Healthcare > **Explanation:** Sectors like construction often deal with long-term contracts involving substantial assets. ### Which accounting standard specifically deals with construction contracts? - [ ] IAS 10 - [ ] IAS 18 - [x] IAS 11 - [ ] IAS 19 > **Explanation:** IAS 11 specifically deals with the accounting treatments for construction contracts. ### What does IAS 18 pertain to? - [x] Revenue - [ ] Expenses - [ ] Liabilities - [ ] Shareholders' Equity > **Explanation:** IAS 18 pertains to revenue recognition principles. ### Which method allocates contract revenue and costs each period based on completed work? - [x] Percentage-of-completion method - [ ] Investment method - [ ] Net realizable value method - [ ] Depreciation method > **Explanation:** The percentage-of-completion method allocates revenue and costs as the project progresses based on the work completed. ### What must be reasonably certain to recognize profit in an ongoing contract? - [x] Assessment of contract outcomes - [ ] Substantial completion of project - [ ] Immediate payment - [ ] Availability of raw materials > **Explanation:** The profit can be recognized if contract outcomes can be reasonably assessed and certain. ### What is typically excluded when calculating attributable profit? - [ ] Costs - [ ] Revenue - [x] Maintenance costs - [ ] Estimation errors > **Explanation:** Attributable profit excludes certain future costs like maintenance yet to be incurred.

Thank you for delving into the intricacies of long-term contracts. Your understanding of these foundational principles can significantly enhance your financial acumen and project accounting proficiency!