In applying percentage of completion accounting based on an output measure (e.g., completion of physical proportion of contract work), how should incurred costs be accounted for ? The following example is used to illustrate the issue. Assume that all contract costs incurred in each period can be attributed to the output in that period.
View 1: Allocate costs in the same proportion as revenue
AS-7, paragraph 21 requires both contract revenue and contract costs to be recognised as revenue and expenses by reference to the stage of completion. Paragraph 24 also states that contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit that can be attributed to the proportion of work completed. Therefore when revenue is recognised based on an output measure, the actual incurred contract cost should be allocated pro rata between expenses and inventory. This view results in the same gross margin percentage throughout the contract period as can be seen below.
View 2:
Recognise costs as incurred
Paragraph 25 indicates that contract costs usually are recognised as an expense in the accounting periods in which the work to which they relate is performed. Paragraph 26 requires incurred costs that related to future activity to be recognised as assets. Therefore incurred costs that can be attributed to activity in the current period should be expensed. This view results in a changing gross margin percentage throughout the contract period.
Conclusion:
As can be seen from a plain reading of the standard, two views are possible. The standard-setters should clarify this issue, so that there can be uniformity in practice on this issue.
