The Percentage of Completion Method Explained

Accounting for income and expenditure can present a real problem for contractors, especially for long-run projects. The percentage of completion method is one of construction’s most regular accounting methods. This method recognises revenue and expenses based on the project’s progress, providing a more accurate financial picture. It involves estimating the project’s total cost and comparing it to current expenses. Contractors can better manage their finances by aligning income with the work performed and costs incurred. This article explains how the percentage of completion accounting method really works and provides real-life examples to illustrate its application.

What Does Percentage of Completion method Mean?

It is an accounting technique used primarily in construction and other long-term projects. It recognises project revenue and expenses proportionally based on the project’s progress during the period. This method contrasts with the completed contract method, which defers the recognition of project revenue and expenses until project completion. The percentage of completion method offers a more accurate financial picture, aligning income with work performed and incurred costs. It is essential that the project’s costs and completion rate can be reasonably estimated and that payment collection is assured.

Understanding the Percentage of Completion Method

It is an accounting technique used to recognise revenue and expenses in construction projects proportionate in cost to cost method of the work completed. This method involves estimating the total estimated cost of a project and comparing it to the costs incurred to date. Revenue is accepted based on the percentage of work completed, which is determined by dividing the expenses incurred to date by the total estimated costs. This approach provides a more accurate financial picture of a project’s progress and profitability, allowing for adjustments as the project evolves. It is commonly used for long-term contracts to match revenues with associated costs.

How to calculate the percentage of completion?

The most regular way to determine a project’s cost to cost percentage of completion is by comparing the total estimated contract costs and actual project costs, known as the “cost-to-cost” method:

Percent Complete = Total Estimated Costs÷Total Costs to Date​

The total percentage of costs incurred represents the full cost to cost project’s completion percentage current accounting period. This percentage is then multiplied by the total contract amount to determine the revenue to recognise during the period:

Revenue Recognised = Percent Complete×Contract Amount

Alternatively, the percentage of completion can also be calculated using units labor hours or labour hours, depending on the nature of the business. The key is consistency in the method used to calculate the percent percentage complete.

The work-in-progress report summarises the information used in the calculation of the percentage of completion. It includes the total corrected contract amount, total costs to date, percent complete based on cost, amount invoiced to date, percentage completion amount, and the difference between contract price, the amount invoiced and the percent of revenue that can be recognised.

Percentage of completion example

For example, a project with calculated costs of $100,000 has obtained $50,000 in costs so far. Dividing the incurred costs ($50,000) by the total estimated costs ($100,000), you determine that the project is 50% complete.

Percent complete: $50,000 ÷ $100,000 = 0.5 (50%)

This indicates that the contractor recognises project income and can recognise half of the total revenue for the project on income statement. If the contract is worth $120,000, the contractor would record $60,000 in revenue for the period, which would be considered in their income statement.

Revenue Recognised=120,000×50%=60,000

IRS requirements

The IRS generally mandates using the percentage of completion method for long-term construction contracts. Exceptions apply for home and construction firms and small contractors. A contract qualifies as small if completed within two years and the contractor’s average gross receipts over the previous three years do not exceed $25 million.

Both criteria must be met to use the completed contract or completion method percentage. Generally Accepted Accounting Principles (GAAP) require recognising revenue when earned, making the percentage of completion method appropriate for most long-term projects. International Financial Reporting Standards (IFRS 15) require that stored materials not constitute completed work be treated separately in income recognition.

Risks with the percentage of completion method

The Percentage of Completion method, while effective for matching revenue with project progress, can pose several risks. One major challenge is that this accounting approach might only sometimes align with the actual financial status on the job site.

Discrepancies can occur between recognised revenue and expenses versus actual billed, actual amounts billed, and expenditures. This misalignment can lead to cash flow issues for contractors, as they might need more time to receive payments or encounter unexpected costs. Proper management of cash flow problems and regular reconciliation of accounting records with actual project data are essential to reduce these risks and ensure financial stability throughout the project lifecycle.

The Percentage of Completion method, while beneficial for recognising revenue over the life of a project, carries several risks, such as:

Overbilling & underbilling

Over-billing occurs when a contractor bills more than the work completed, leading to cash flow issues or potential client disputes. On the other hand, under-billing happens when a contractor bills less than the work performed, to create cash flow problems, which can affect cash flow and working capital. Both scenarios can distort financial reporting and impact project profitability, as revenue and expenses might need to align with actual progress and costs.

Change orders

Change orders, which modify the original contract scope or terms, can complicate internal accounting process and revenue recognition. Adjustments for change orders must be accurately estimated and incorporated into the percentage of completion calculation. Incorrect handling of change orders project expenses can lead to revenue misstatement, profit margin issues, and disputes over the fair value of the work performed.

Percentage of completion helps accurately recognise revenue

The Percentage of Completion method is usually used by commercial contractors, including general and speciality contractors, to report revenue. This method is particularly effective for projects lasting several months or longer, as it provides a more accurate reflection of income based on work completed.

However, accurate revenue recognition doesn’t guarantee financial health if payments aren’t collected. For contractors, cash flow is crucial; the revenue recognised must translate into actual cash inflows to sustain operations orders project expenses. Regardless of the accounting approach, securing timely payments and managing cash flow effectively are essential practices to ensure financial stability and project success.

Percentage of Completion vs Completed Contract

Distinctions between the Percentage of Completion method and the Completed Contract method are: