The principal concern of accounting for long-term construction contracts involves the timing of revenue (and profit) recognition. It has been well accepted that, given the long-term nature of such projects, deferring revenue recognition until completion would often result in the presentation of periodic financial reports that fail to convey the true level of activity of the reporting entity during the period. In extreme cases, in fact, there could be periods of no apparent activity, and others of exaggerated amounts, when in fact the entity was operating at a rather constant rate of production during all of the periods. To avoid these distortions, the percentage of completion method was developed, which reports the revenues proportionally to the degree to which the projects are being completed, even absent full completion and, in many cases, even absent the right to collect for the work done to date.
The major challenges in using percentages of completion accounting are to accurately gauge the extent to which the projects are being finished, and to assess the ability of the entity to actually bill and collect for the work done. Since many projects are priced at fixed amounts, or in some other fashion prevent the passing through to the customers the full amount of cost overruns, the computation of periodic profits must be sensitive not merely to the extent to which the project is nearing completion, but also to the terms of the underlying contractual arrangements.
IAS 11 is the salient international standard addressing the accounting for construction contracts and other situations in which the percentage of completion method of revenue recognition would be appropriate. This standard uses the recognition criteria established by the IASC's Framework as the basis for the guidance it offers on accounting for construction contracts. The various complexities in applying IAS 11, including the estimation of revenues, costs, and progress toward completion, are set forth in the following discussion.
IAS 10, 11, 23, 37