Use the percentage-of-completion method when you record revenue from long-term contracts in stages. With this method, you recognize revenue, costs, and gross profits throughout the life of each contract, based on a periodic measurement of progress. Accountants use two specific accounts in the chart of accounts for the percentage-of-completion method (PCM):
Construction in process: This inventory asset account shows accumulated construction costs and gross profit earned as of the date of the balance sheet.
Billings on construction in process: Use this contra inventory account to accumulate progress billings.
GAAP dictates that businesses with long-term contracts use the PCM when both the estimates regarding progress made toward completion of the contract and the revenue and costs associated with the contract are reasonably dependable — and when all the following additional conditions are met:
Terms of the contract: The contract must clearly spell out enforceable rights regarding the goods or services, the consideration exchanged, and the terms of settlement.
Buyer obligations: There’s a reasonable expectation that the buyer will live up to his end of the contract.
Contractor obligations: There’s a reasonable expectation that the contractor will live up to his end of the contract.
Accounting for the PCM method can be quite subjective and open to error.
International Accounting Standard (IAS) 11 includes instructions to use the percentage-of-completion method when the outcome of a construction contract can be reasonably estimated. If the outcome cannot be reasonably estimated, no profit should be recognized. Contract revenue should be recognized only to the extent that contract costs are incurred.