In this workout, we've been told that a company has entered into a three-year contract with a customer for a fixed fee of 100. And management have estimated that total contract costs will be 80. We've been asked to calculate contract revenues and profits throughout the three years, given the information below on actual costs incurred in each year, and we've also been asked how revenues and profits would change if there are cost overruns of 10 in year three.

Now, the first thing we can do is calculate overall contract profits, and that's simply contract revenue of 100 minus contract costs estimated to be 80. giving overall contract profit of 20.

Now let's have a look at how we allocate that contract profit to each of the three years.

The important piece of information here is that we have contract costs actually incurred in each of the three years of 20, 50 and 10 in years one, two, and three respectively. And that's important because the amount of revenue that's recognized in each year is going to be based on the proportion of contract costs incurred in each year relative to the total estimated contract costs. This is sometimes referred to as cost to cost accounting. So in year one, we can see we've got contract costs of 20 compared to the total contract costs of 80, which means that we've incurred 25% of the total contract costs in year one. That means that we're allowed to recognize 25% of the contract revenues in year one as well. So let's put that into a formula. We start off by taking the cost incurred of 20, and we divide this by the total contract costs of 80. That's estimated total contract cost of 80, showing that we've got the 25% of costs incurred in the year. And then we multiply this by the overall contract revenues of 100. What this gives us is 25% of the overall contract revenues that we can recognize in year one. And in terms of our profits take 25 and minus the 20 to give us recognized profit in year one of five, and that also is 25% of the total estimated contract profits. Once we've locked onto the revenue of 100, we can then copy this to the right for year two, giving us 62.5 of revenue, reflecting the fact that 62.5% of the overall contract costs have been incurred in year two, and we can also copy across the profit to give us 12.5 in year two. Now in year three, we've gotta be a little bit careful just to calculate the revenue being our overall revenue minus all of the revenue that's already been recognized in the previous years, and that gives us in year three, 12.5 of revenue. And that makes sense because in year three, we've incurred 10 of expenses, which equates to 12.5% of the overall estimated contract costs.

We can copy across the profit to give us 2.5 of profit in year three, but now let's have a think about how revenues and profits change if there are cost overruns of 10 in year three. So let's replace the 10 with 20 of contract costs. And now we see instead of recording a profit in year three, we've got a loss of 7.5 and that even though the contract as a whole is still profitable because contract revenues of a hundred still exceed the total contract cost of 90, this reflects the fact that management have actually recognized too much revenue and profit in years one and two because they underestimated contract costs upfront. This highlights a major risk associated with contract accounting. It's hugely dependent on the upfront cost estimates provided by management. So if management underestimate contract costs, they'll accelerate revenue and profit recognition. So how can we spot this issue in the accounts? Well, accelerated revenue recognition will give rise to increased levels of accrued income, and this will be evident in a couple of places. Firstly, we'll see increased working capital outflows in the cashflow statement where profits are reconciled to operating cash flows. And secondly, we'll see increased levels of accrued income within current assets. Also, if this is an ongoing issue, we'll see elevated level of contract impairments, and these may be flagged in the non reconciliation.