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  Long Term Contracts

Introduction to Long-term contracts

Both for goods and for services a number of contracts can last for more than one accounting period. If the business giving the goods or service were to wait until the contract is totally fulfilled before recognising revenue, the income statement could provide a misleading notion of the wealth produced in the several accounting periods covered through the contract. This is a specific problem for businesses that undertake main long-term contracts, in which a single contract could demonstrate a large proportion of their total activities.

  • Construction contracts

Construction contracts frequently expand over a long period of time. Assume that a customer enters into a contract along with a builder to have a new factory built which will take 3 years to complete. In such type of a situation, it is feasible to identify revenue before the factory is completed given that the building work can be split into a number of stages and each stage can be computed reliably. Let us presume that building the factory could be split into the following stages:

Stage 1 - clearing and levelling the land and putting in the foundations.

Stage 2 - building the walls.

Stage 3 - putting on the roof.

Stage 4 - putting in the windows and completing all the interior work.

Every stage can be rewarded a separate price with the total for all the stages being equivalent to the total contract price for the factory. The meaning of this is as each stage is finished; the builder can identify the price for that stage as revenue and bill the customer accordingly. This is given that the result of the contract as a whole can be estimated reliably.

Before recognising revenue if the builder were to wait until the factory was completed, the income statement should covering the final year of the contract would identify all of the revenue on the contract and the income statements for each previous year would recognise no revenue. This would provide a misleading impression, because it would not imitate the work done during each period.

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