Accounting For Construction- Type and Production-Type Contracts

  July 20, 2022

Accounting For Construction- Type and Production-Type Contracts Residing in ASC 605-35 and As Superseded by ASC 606

ASC 605-35 provides guidance on Accounting Principle Generally Accepted in United States of America for the following types of customer performance contracts:

  • Facility Construction
  • Production of Goods, and
  • Performance under Related Services

The standard addresses when to recognize revenue and corresponding costs over a long-term contract over a relatively shorter accounting reporting period. The standard establishes two methods of accounting of such contracts and are not to be considered as alternative since there are specific requirements to meet each:

Percentage Completion – One is allowed to recognize revenue as work progresses

Completed Contract – One is allowed to recognize revenue only once the work in completed

Units of Delivery – Contracts that contain units to be delivered recognize revenue as units are completed and delivered. This method is considered an extension of the percentage completion method. 

Accounting these types of contracts involves following knowledgeable and consistent application of costing methods. The process is very reliant of reporting entity’s ability to estimate the extent of progress made in completion, the contract revenues, and the contract costs. The contractors that have good experience with contracting operations would have the ability to make reliable contract estimates and would prefer and will be allowed to use percentage-of-completion method of accounting. 

Under the completed-contract method, income is recognized once the contract is substantially completed. However, until the contract is substantially completed billing and costs are accumulated on the balance as a liability and asset, respectively. This method is appropriate where reasonable estimates of extent of completion, contract revenues, contract costs cannot be made, and the contractors income statement and balance sheet would not vary materially if percentage-of-completion method was used. 

ASC 605-35 applies to all contracts and not limited to construction contracts. The guidance becomes more pertinent when the contracts are long term in nature. Typical contracts that would fall within the scope of this standard are:

  • Construction industry
  • Ships and transport vehicles industry
  • Aerospace and electronic equipment industry
  • Architecture industry
  • Engineering industry

Computer software or computer systems industry

ASC 605-35 classifies contracts into the following categories which are based on how they are being priced:

  • Fixed Price – The price under the contract is fixed
  • Cost-type (including cost-plus) – The contract is priced at costs of all activities under the contract plus a fixed fee or percentage of costs
  • Time-and-material – The price is based on a fixed rate per hour for all activities plus actual cost of materials
  • Unit-price – The contract is priced at fixed price per unit of output

These contracts may contain further provisions for incentives, penalties, or modifications of terms.

Cost Elements

In any contract performance there are two elements: costs incurred through the measurement date and estimated cost to complete. The costs incurred can be reasonably determined if the cost accounting systems used are adequate and effective. Estimating costs to completed can be more uncertain.

Costs incurred through a measurement date can be identified and recognized based on the following principles:

  • All direct costs (material, labor, subcontractors)
  • Indirect costs (labor, tools and equipment, supervisory, supplies, etc.)
  • General and administrative costs are all expensed
  • Selling costs are capitalized but netted in determining gain on sale
  • Cost-type contract may be all charged to contract
  • In estimating gross profit or loss on a contract all costs to complete must be reasonably estimable
  • Capitalized or inventoried costs cannot be greater than the estimable realizable value of the contract

The more difficult estimate is cost to complete should be determined based on the following principles:

  • Systematic and consistent procedures along with cost accounting systems that provide a basis for comparing actual vs estimates
  • Quantities and prices of significant cost elements
  • Estimation procedures that include the same inputs as that of actual
  • Consideration for future wages and price increases
  • Periodic review of new information used in estimation inputs

Grouping of Contracts

Under the standard and ASC 606 each contract is considered a profit center for revenue recognition, cost accumulation and income measurement. If a group of contracts are so closely related that they may be considered parts of a single project and as such maybe combined for profit determination. Following criteria must be met for contracts to be group together:

  1. The contracts are negotiated as a single package with overall profit determination
  2. The group of contracts are part of a single agreement to perform a single project
  3. The contracts require performance of closely interrelated construction activities with common costs
  4. The contracts that are part of a single agreement with the same customer

Either a single contract or a group of contracts which even though meet the above grouping test, they may have components that were negotiated separately, and can divided into separate segments if the following criteria are met:

  • The contractor proposed on separate components and on the entire project
  • The customer had the right to accept proposal for only some of the components or the entire project
  • The sum of the components of the proposal approximates the total amount of the entire project

Adjustments to Estimates

As a contract progresses and more information is obtained and learned, adjustments to total revenue, total cost and estimate to complete may be required. Such adjustments should be made in accordance with ASC 250, Accounting Changes and Error Corrections. 

Provision for Anticipated Losses

If losses are expected on current contract, a provision for the loss should be made for either of the two types of contracts, completed-contract or percentage-of-completion methods, and should be accounted for in the period loss becomes evident. 

If you have any question on Accounting for Construction-Type and Production-Type Contracts feel free to contact us at kislay@shahcpaus.com or call at 646-328-1326 with your inquiries.