Aerospace & Defense Spotlight — Considerations Related to the Estimate-at-Completion Process (December 7, 2023)

Aerospace and defense companies often have contracts for which revenue is recognized over time in accordance with ASC 606.1 These contracts may require companies to develop an estimate at completion (EAC) if the cost input method (i.e., costs incurred) is used to measure progress. An EAC represents management’s best estimate of the costs to complete a contract and can involve significant judgment since the EAC is the sum of actual costs incurred to date and the estimate-to-completion (ETC) costs. This spotlight identifies key considerations related to the process of developing and monitoring EACs and is intended to supplement the considerations in Deloitte’s Roadmap Revenue Recognition.

An EAC comprises the total revenue expected to be recognized for the contract2 and the EAC costs. Costs should be identifiable at the performance obligation3 level and by type (e.g., direct labor, direct materials, subcontractors, and overhead costs). Because costs incurred are often the measure of progress for recognizing revenue, companies should remember to clearly identify any incurred costs that may not represent the overall progress of the program. For example, costs that are correlated with the measurement of progress include direct labor, direct materials, and allocation of costs directly associated with the contract (e.g., contract management and supervision). An entity must use judgment in evaluating whether certain expenses or expenditures represent progress on the contract (e.g., certain advanced payments to vendors, common inventory, uninstalled materials).

Given the diversity of information and estimates included in an EAC, various personnel from management and the functional departments should be involved in the EAC process. Such departments may include finance, purchasing, contracts, legal, business development, program management, operations, and engineering. The key to the EAC process is to avoid making high-level assumptions and instead involve the individuals in the best position to develop and validate assumptions used in the estimation process. For example, engineers would develop and review design estimates, operations leaders would review the required materials and labor to build products and develop initial estimates related to these designs, and the finance and purchasing departments would be able to apply the appropriate costs to the underlying estimates of hours. Companies should also consider the views of middle and upper-level management on expected changes to the overall business (e.g., cost reduction, scale of future operations for overhead rate purposes) when developing EACs.

Because of their evolving nature, EACs should be updated regularly to reflect management’s best estimate; any changes in the estimates should be incorporated in a timely manner. EACs can be prepared by using a bottoms-up or top-down method. In a bottoms-up process, ETCs are reestimated by updating the underlying basis of estimate (BOE) for the most current information. A bottoms-up EAC is more appropriate when there is less certainty in the BOE, relatively significant changes in estimates are expected, or the company’s EAC policy requires such a method. A top-down EAC affects ETC changes from a higher-level perspective. For example, if no significant changes to the estimates are expected or such changes are limited to specific ETCs, the company would only need to update those ETCs with changes in lieu of reestimating all ETCs for the period. Companies must use judgment in determining whether a bottoms-up or top-down EAC is more appropriate.

Any changes in estimates made as part of the EAC update process that cause a change to the EAC margin rate will result in a cumulative catch-up adjustment to reflect the impact of the change in all prior periods on the basis of the percentage complete. These changes must be reviewed in detail to ensure that the amount and timing of the adjustment is appropriate (i.e., whether the adjustment results from new information ascertained in the current period or information that should have been known previously).

The following are some best practices for the EAC process:

• Consider the different information used and the nature of the review performed for contracts with different fee types (e.g., fixed, award, cost incentive, schedule incentive, or performance incentive fee structures).
• Ensure that the EAC is based on the most current information by consistently monitoring any contract modifications, change orders, etc., that could change the contract value (EAC revenue), scope of work, or fee structure. Submission of requests for equitable adjustments, claims, or contractual liquidated damages could potentially also have an impact on EAC revenue.
• Consider the benefits of setting a threshold related to identifying a population of contracts for which an EAC is not required or is required less frequently (e.g., contracts with a total contract value below $1 million). In setting such a threshold, management would use judgment and consider the contract portfolio, average contract value, and other factors.
• Ensure that the process and review are consistent for contracts with similar characteristics (e.g., product, service, contract type).
• Use available historical information, such as contracts with similar scopes of work and deliverables, to help develop a basis for cost estimates and risks and opportunities present on similar contracts.
• Retain evidence of the development and review of the EAC for both internal records and to support internal and external audits.