Revenue recognition in the case of long-term contracts

Principles of German accounting law

German accounting law is strongly characterised by the principle of prudence. In order to protect creditors, in cases of doubt, asset valuations should rather be conservative while liabilities should be recognised at high values. Revenues should only be taken into account here if they have been realised on the reporting date (the so-called realisation principle). The revenues should be ‘virtually certain’ in this case. In the area of works contracts, under German accounting law, revenues are thus only realised after a project has been completed. That is normally when the work has been accepted. This means that, up to that point, any progress payments received for the project should be recognised as a liability under ‘advance payments received’ in a way that does not affect the operating result for tax purposes and the services performed should be capitalised as work in progress. Revenues would only be realised in the year of completion or acceptance of the work in one go (the so-called completed contract method). If as a result of this there is a significant distortion of the profit situation then this would have to be explained in the notes to the accounts by providing appropriate information.

Alternative courses of action

The question that now arises is to what extent is it possible, under German law, - beyond reporting in the notes to the accounts - to lessen any severe distortions of the profit situation. Here, there are the following courses of action.

Sub-projects for partial revenue recognition 

First of all, already in the course of formulating long-term contracts, you could try to define sub-projects and invoice and accept them separately. In the case of such partial acceptances, the contractual objects would have to be legally and economically transferred to the customer (transfer of risk). Insofar as it is thus possible to transfer the risk to the customer, the revenues would then be partially realised. The necessary transfer of risk would, moreover, require partial performance that could be identified on a stand-alone basis and would be self-contained; there could not be any functional connection between each individual partial performance. 

Please note: Whether or not this can be achieved will depend on the contract arrangements and the customer’s willingness to split up the project and assume the transfer of risk in several steps. 

Breach of the realisation principle?

According to a minority viewpoint that can found in specialist literature (cf., for example: IDW, WP-Handbuch, Section F, marginal no. 1351; ADS, HGB-Kommentar, Section 252, marginal no. 88 [only available in German]), under very strict conditions, there is a further possibility to breach the realisation principle described above. The following conditions are cited: 

• These have to be long-term productions that constitute a substantial part of the company’s activities. 
• Invoices issued in accordance with the realisation principle would lead to the presentation of the earnings situation becoming skewed to a not inconsiderable extent. 
• It has to be possible to reliably calculate the revenues from the long-term production without risk. 
• It has to be possible to break up the total performance into notional partial performances and carefully determined partial revenues. 
• There is no indication that there are objections from the customer that could have implications for the overall results.

However, among experts, the acceptability of accounting in such a way is considered to be controversial.

Please note: This approach – splitting up total performance (for example, a large project) into several partial performances and bringing about partial recognitions according to the degree of completion - is also referred to as the percentage of completion method (PoC).

Summary: In summary, it can be said that there are indeed possible ways to spread out the revenues over time from a large project where there is long-term production. However, in a specific case it is likely that this could only be realised under very restrictive conditions so that, normally, the ‘revenues arising in one go’ approach would apply, thus once the project is accepted after having been completed. This is also the viewpoint for tax purposes. This means that the revenues from these types of projects will likewise arise only once the work has been accepted right at the end and this will accordingly trigger high tax charges. This can nevertheless have a positive effect in terms of liquidity (under the heading of: tax credit).