Northrop Grumman 2010 Annual Report Download - page 43

generally accepted in the United States of America (GAAP) for construction-type and production-type contracts
and federal government contractors. We classify contract revenues as product sales or service revenues depending
on the predominant attributes of the relevant underlying contract. We also enter into contracts that are not
associated with the federal government, such as contracts to provide certain services to non-federal government
customers. We account for those contracts in accordance with the relevant GAAP revenue recognition principles.
We consider the nature of these contracts and the types of products and services provided when determining the
proper accounting method for a particular contract.
Percentage-of-Completion Accounting – We generally recognize revenues from our long-term contracts under the
cost-to-cost or the units-of-delivery measures of the percentage-of-completion method of accounting. The
percentage-of-completion method recognizes income as work on a contract progresses. For most contracts, sales
are calculated based on the percentage of total costs incurred in relation to total estimated costs at completion of
the contract. For certain contracts with large up-front purchases of material, primarily in the Shipbuilding
segment, sales are generally calculated based on the percentage that direct labor costs incurred bear to total
estimated direct labor costs. The units-of-delivery measure is a modification of the percentage-of-completion
method, which recognizes revenues as deliveries are made to the customer generally using unit sales values in
accordance with the contract terms. We estimate profit as the difference between total estimated revenue and
total estimated cost of a contract and recognize that profit over the life of the contract based on deliveries.
The use of the percentage-of-completion method depends on our ability to make reasonably dependable cost
estimates for the design, manufacture, and delivery of our products and services. Such costs are typically incurred
over a period of several years, and estimation of these costs requires the use of judgment. We record sales under
cost-type contracts as costs are incurred.
Many contracts contain positive and negative profit incentives based upon performance relative to predetermined
targets that may occur during or subsequent to delivery of the product. These incentives take the form of
potential additional fees to be earned or penalties to be incurred. Incentives and award fees that can be
reasonably assured and reasonably estimated are recorded over the performance period of the contract. Incentives
and award fees that are not reasonably assured or cannot be reasonably estimated are recorded when awarded or
at such time as a reasonable estimate can be made.
Other changes in estimates of contract sales, costs, and profits are recognized using the cumulative catch-up
method of accounting. This method recognizes in the current period the cumulative effect of the changes on
current and prior periods. Hence, the effect of the changes on future periods of contract performance is
recognized as if the revised estimate had been the original estimate. A significant change in an estimate on one or
more contracts could have a material effect on our consolidated financial position or results of operations.
Certain Service Contracts – We generally recognize revenue under contracts to provide services to non-federal
government customers when services are performed. Service contracts include operations and maintenance
contracts, and outsourcing-type arrangements, primarily in Technical Services and Information Systems. We
generally recognize revenue under such contracts on a straight-line basis over the period of contract performance,
unless evidence suggests that the revenue is earned or the obligations are fulfilled in a different pattern. Costs
incurred under these service contracts are expensed as incurred, except that direct and incremental set-up costs
are capitalized and amortized over the life of the agreement. Operating profit related to such service contracts
may fluctuate from period to period, particularly in the earlier phases of the contract.
Contracts that include more than one type of product or service are accounted for under the relevant GAAP
guidance for revenue arrangements with multiple-elements. Accordingly, for applicable arrangements, revenue
recognition includes the proper identification of separate units of accounting and the allocation of revenue across
all elements based on relative fair values.
Cost Estimation – The cost estimation process requires significant judgment and is based upon the professional
knowledge and experience of our engineers, program managers, and financial professionals. Factors that are
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