Question with regards to reliable estimates of a contract…

A firm that reports under IFRS has begun providing a product under a long-term contract for which it cannot reliable estimate the outcome. In the first year of this contract, compared to reporting under US GAAP, reporting under IFRS will cause the firm’s operating profit margin to be:

A. Lower

B. Higher

C. the same

Under IFRS, long-term contracts that are unreliable, revenue is recognized to the extent of the costs.

Under US GAAP, long-term contracts that are unreliable, revenue, expenses and profit are recognized at completion.

Based on the above I would say my answer is B. If revenue is recognized to the extent of contract costs then presumably revenue and expenses were reported for the first year. However, the correct answer is A. Why?

Well under IFRS you’re essentially grossing up the costs as well as revenues by a nil margin contract. I.e if you’re a profit making company, then the margin on this is lower (well its nil) compared to the rest of your contracts, hence it brings your overall margin down.

I see. Essentially, we are to assume that this project is just a portion of their business and not their entire business.