Northrop Grumman 2011 Annual Report Download - page 74

NORTHROP GRUMMAN CORPORATION
Revenue Recognition – The majority of the company’s business is derived from long-term contracts for production
of goods, and services provided to the federal government. In accounting for these contracts, the company
extensively utilizes the cost-to-cost and the units-of-delivery measures of the percentage-of-completion method of
accounting. Sales under cost-reimbursement contracts and construction-type contracts that provide for delivery at
a low volume per year or a small number of units after a lengthy period of time over which a significant amount of
costs have been incurred are accounted for using the cost-to-cost method. Under this method, sales, including
estimated earned fees or profits, are recorded as costs are incurred. Sales under contracts that provide for delivery at
a high volume per year are accounted for using the units-of-delivery method. Under this method, sales are
recognized as deliveries are made to the customer generally using unit sales values for delivered units in accordance
with the contract terms. The company estimates profit on units-of-delivery contracts as the difference between
total estimated revenue and total estimated cost of a contract and recognizes that profit over the life of the contract
based on deliveries or as computed on the basis of the estimated final average unit costs plus profit. The company
classifies contract revenues as product sales or service revenues depending upon the predominant attributes of the
relevant underlying contracts.
Certain contracts contain provisions for price redetermination or for cost and/or performance incentives. Such
redetermined amounts or incentives are included in sales when the amounts can reasonably be determined and
estimated. Amounts representing contract change orders, claims, requests for equitable adjustment, or limitations in
funding are included in sales only when they can be reliably estimated and realization is probable. In the period in
which it is determined that a loss will result from the performance of a contract, the entire amount of the
estimated ultimate loss is charged against income. Loss provisions are first offset against costs that are included in
unbilled accounts receivable or inventoried costs, with any remaining amount reflected in liabilities. Changes in
estimates of contract sales, costs, or 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 or prior periods.
Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimate
had been used since contract inception.
Changes in contract estimates occur for a variety of reasons including changes in contract scope, unforeseen changes in
contract cost estimates due to unanticipated cost growth or risks affecting contract costs and/or the resolution of contract
risks at lower costs than anticipated, as well as changes in contract overhead costs over the performance period. The
company has an extensive contract management process involving several functional organizations and numerous
personnel who are skilled at managing contract activities. Because the company’s business involves performing on a
broad portfolio of long-term contracts, generally involving complex customized products and services principally for its
U.S. Government customers, changes in estimates occur routinely over the contract performance period. Significant
changes in estimates on a single contract could have a material effect on the company’s consolidated financial position or
annual results of operations, and where such changes occur, separate disclosure is made of the nature, underlying
conditions and financial impact of the change. Aggregate net changes in contract estimates recognized using the
cumulative catch-up method of accounting increased operating income by $738 million ($1.70 per diluted share) in
2011, $675 million ($1.46 per diluted share) in 2010, and $421 million ($0.85 per diluted share) in 2009. No discrete
event or adjustments to an individual contract within the aggregate net changes in contract estimates for 2011, 2010 or
2009 was material to the consolidated statement of operations for such annual period.
Revenue under contracts to provide services to non-federal government customers are generally recognized when
services are performed. Service contracts include operations and maintenance contracts, and outsourcing-type
arrangements, primarily in the Information Systems and Technical Services segments. Revenue under such contracts
is generally recognized 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 (see Outsourcing Contract Costs below). Operating profit related to such service contracts may fluctuate
from period to period, particularly in the earlier phases of the contract. For contracts that include more than one type
of product or service, revenue recognition includes the proper identification of separate units of accounting and the
allocation of revenue across all elements based on relative fair values.
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