What happens when a long-term contract is expected to result in an overall loss?

This is one of the most important (and most tested) rules in long-term contract accounting: when a contract becomes onerous (expected total costs exceed the contract price), the entire estimated loss must be recognized immediately in the period the loss becomes apparent — regardless of the percentage completed.

This rule applies under BOTH US GAAP and IFRS.

Why Immediate Recognition?

This is an application of the conservatism principle (prudence under IFRS). While gains are recognized gradually as earned, losses must be recognized as soon as they are probable. Deferring a known loss would overstate assets and mislead financial statement users.

Worked Example — Northpoint Builders:

Northpoint has a $20,000,000 fixed-price contract. Original estimated total costs = $17,000,000 (expected profit = $3,000,000).

After Year 1, a design change and material cost increases cause Northpoint to revise estimated total costs to $22,000,000.

At the end of Year 1, Northpoint has incurred $5,100,000 in costs (% complete = $5,100,000 / $22,000,000 = 23.18%).

Under Percentage of Completion — Loss Recognition:

Revenue recognized = 23.18% × $20,000,000 = $4,636,364

Expected total loss = $2,000,000

The company must recognize enough loss so that the cumulative effect reflects the FULL expected loss:

Cumulative loss to recognize = Costs to date − Revenue to date + Remaining expected loss

= $5,100,000 − $4,636,364 + ($22,000,000 − $5,100,000 − ($20,000,000 − $4,636,364))

= $2,000,000 (total expected loss recognized in Year 1)

Balance Sheet Treatment:

A provision for estimated loss on contract (liability) is created for the remaining loss not yet incurred. This ensures the full loss is reflected even though the costs have not yet been paid.

Key Exam Points:

1. Profitable → Loss: When estimates change from profit to loss, recognize the ENTIRE expected loss immediately.
2. Under completed contract method: Same rule — the full loss is recognized immediately, even though no revenue has been recorded yet.
3. Reversal: If conditions improve in a later period and the contract returns to profitability, the provision is reversed — but you never reverse more than was originally recognized.

Practice loss recognition scenarios in our CFA Level I question bank.