Question

What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other of these methods should be used.

Short answer

If a company can accurately forecast its progress toward satisfying performance commitments, it can recognize income over time. For example, the percentage-of-completion method recognizes revenues and gross profits each quarter based on the building's development.

Step-by-step solution

Long-Term Construction Contracts

A long-term contract is for the construction, installation, construction, or manufacture of property that starts one year and ends in a subsequent tax year.

Circumstances that determine when one or another method used

There are two basic methods of accounting for long-term construction contracts:

1. Percentage-of-completion method
2. Completed-contract method

Companies often record revenue at the moment of sale since the performance obligation is fulfilled at that time. Companies may recognize income over time in certain conditions. Long-term construction contract accounting is the most noteworthy example of revenue recognition over time. Long-term contracts usually provide that the seller (builder) may bill the buyer at regular intervals as the project progresses.

If at least one of the following three requirements is satisfied, a corporation fulfills a performance obligation and recognizes income over time:

1. As the entity performs, the customer simultaneously obtains and consumes the advantages of the entity's performance.
2. The company's performance generates or improves an asset (for example, work in progress) that the client has control over as it is being generated or improved.
3. The company's success does not result in the creation of an asset with a secondary purpose. The asset, for example, cannot be used by another customer. A minimum of one of the following criteria must be satisfied in addition to this alternate usage element:

(a) If another firm were to fulfill the remaining commitmentto the client, it would not be necessary for that other company to re-perform the work that has already been performed substantially.

(b) The firm is entitled to payment for work done to date, and it expects to finish the contract as agreed.

As a result, if either criteria 1 or 2 are fulfilled, a corporation can recognize revenue over time if it can properly predict its progress toward meeting the performance commitments. That is, the percentage-of-completion technique acknowledges revenues and gross profits each quarter depending on the progress of the building. The argument for utilizing percentage-of-completion accounting is that most of these contracts involve legal rights for both the buyer and the seller. The buyer has the legal right to insist on the contract's specified fulfillment. The seller has the authority to demand advance payments as proof of the buyer's ownership interest. As a result, as the project proceeds, a continual sale happens. Revenue should be recognized by this development.