Operating profit margin under IFRS | long term contracts

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

  • A. lower
  • B. higher
  • C. the same

Answer: A

I thought under IFRS, if the outcome of a long term contract cannot be estimated reliably, the firm should expense costs when incurred, recognise revenue to the extent of the costs and recognize profit only when the contract is complete.

U.S. GAAP: completed contract method, only recognise revenue, expenses and profit when the contract is complete.

Therefore, how can a firm reporting under IFRS have lower operating profit margin than a firm reporting under U.S. GAAP?

Their operating profit (in dollars, euro, pounds, yen, whatever) will be the same, but under IFRS their revenue will be higher (recognized to the extent of costs, compared to US GAAP: no revenue recognized). The same profit divided by higher revenue results in a lower profit margin.

Ahh okay, so we assume only revenue is recognised from the long term contract under IFRS?

What if we expensed costs too, this would reduce EBIT and lead to an ambiguous outcome?

Under IFRS, equal amounts of revenue and cost are added to income statement. This will REDUCE operating profit margin.

Imagine Sales = 100, Costs = 50, EBIT = 50, Operating Profit Margin = 50%.

Now imagine the Costs and Revenue added to Income Statement in first year are 20 (remember, you can only add as much revenue as your costs until project completed, so both are equal).

Now Sales = 120, Costs = 70, EBIT = 50 (same as before), Operating Profit Margin = 42% (lower)

Revenues are recognized _ to the extent of costs _; they net to zero, just as if you’d recognized nothing.

No ambiguity.

Brilliant! :slight_smile: thanks guys

My pleasure.