Percentage of Completion Method
Refers to an accounting method that recognizes revenue for different periods for a long-term project or contract
What Is The Percentage Of Completion Method?
The percentage of completion is an accounting method that recognizes revenue for different periods for a long-term project or contract. The percentage of work completed in a period calculates revenue, expenses, and estimated gross profit.
Many companies misuse this method to bolster their short-term results. However, this method should be used only when there is very little credit risk and the percentage of contracts completed can be measured effectively and efficiently.
The current period costs and current period revenue are balanced with total estimated costs to calculate tax liability for a particular period.
For example, let's say there's a construction project which was 55% completed after the end of the second year and only 30% at the start of the 2nd year.
This would mean that only 25% of the contract was completed in the second year, and revenues relating to that 25% of work should be recognized for the current period.
When using this method, the balance sheet is prepared just as in the case of a completed contract method; the adjustments have to be made in the P&L statement only.
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The Percentage of Completion method is used in accounting to recognize revenue and expenses for long-term projects or contracts over different periods.
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Companies should use this method cautiously, ensuring there is minimal credit risk and accurate measurement of contract completion.
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Three different methods to calculate the Percentage of Completion include: Cost-to-cost, Efforts-expended, and Units-of-delivery methods.
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The method helps in recognizing revenue and expenses based on the progress of the project, allowing for more accurate financial reporting.
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While advantageous in providing a detailed view of a company's financial performance, the method's reliance on estimates can lead to uncertainties and potential manipulation of profits and losses.
Different methods to calculate the percentage of completion
Calculating the percentage of completion is essential in many fields, especially in accounting and project management. There are three different ways in which it can be calculated, which are explained below.
Cost-to-cost method
This method is based on the ratio between the cost incurred to date on the contract to the total estimated project cost. If the cost of raw materials has not been taken into use until the end of the period, then it should not be considered when calculating the percentage of completed contracts.
Moreover, the cost of fixed assets used in the construction for only the contract period should be included in the cost of the contract, i.e., the depreciation and amortization of assets used.
Efforts-expended method
In this method, we replace the costs incurred and estimated costs with efforts expended till now and total expected efforts for the contract. Total labor hours, machine hours, or quantity of raw material can be used to measure the completion percentage.
In this method, we replace the costs incurred and estimated costs with efforts expended till now and total expected efforts for the contract. Total labor hours, machine hours, or quantity of raw material can be used to measure the percentage of completion.
Units-of-delivery method
In this method, a contract's completion percentage is measured by the number of units delivered to the total number of units to be delivered for a specific contract.
However, this method can only be used when the producer produces products according to customer specifications.
- The contract price of units delivered is used to recognize revenue.
- The costs reasonably allocable to the units produced are used to identify expenses.
Percentage of Completion Method Examples
XYZ Ltd. took a contract to build an airport at a contract price of $125 million. The estimated cost for the contract is $100 million within three years.
Assuming the estimated cost is constant, the company would make a profit of $25 million. Following is the schedule related to the project:
| 2018 | 2019 | 2020 | |
|---|---|---|---|
| Costs Incurred (Cumulative) | $20,000,000 | $50,000,000 | $100,000,000 |
| Total Estimated Costs | $100,000,000 | $100,000,000 | $100,000,000 |
| Cash Collected | $20,000,000 | $50,000,000 | $30,000,000 |
| % Completed | 20% | 50% | 100% |
From the schedule above, revenues are recognized under the percentage of completion method:
- The year 2018: 20% completed. Revenue recognized = 20% x $125 million (contract price) = $25,000,000
- The year 2019: 50% completed. Revenue recognized = 50% x $125 million (contract price) - $25 million (previously recognized) = $37,500,000
- The year 2020: 100% completed. Revenue recognized = 100% x $125 million (contract price) – $25 million – $37.5 million (previously recognized) = $62,500,000
| Year | Cost Recognized | Revenue Recognized | Profit Recognized |
|---|---|---|---|
| 2018 | $20,000,000 | $25,000,000 | $5,000,000 |
| 2019 | $30,000,000 | $37,500,000 | $7,500,000 |
| 2020 | $50,000,000 | $62,500,000 | $12,500,000 |
| Total | $100,000,000 | $125,000,000 | $25,000,000 |
Percentage of Completion Method Advantages and Disadvantages
Advantages of the Percentage of Completion Method
- Allows for the estimation of costs and revenues over a specific period based on the completed portion of the contract, aiding in the assessment of project value and income recognition to date.
- Encourages the provision of a comprehensive estimate of all associated costs and revenues, even if certain expenses have not yet been incurred in the project.
- Facilitates the spreading of tax liabilities across multiple years, which can prevent a company from overpaying taxes in a given period.
- Enables companies to report expenses annually, potentially lowering tax liabilities and taking advantage of tax deductions.
- Particularly useful in construction project accounting, this method aligns revenues and expenses with the progress of the project, providing a clearer picture of financial performance over the long term.
- Offers a contrast to the completed contract method, recognizing revenue and expenses incrementally as the project advances, rather than waiting until project completion.
Disadvantages of the Percentage of Completion Method
- The revenue reported is based on estimates, which introduces a degree of uncertainty and the potential for bias, making the recognized revenue somewhat speculative.
- There is a risk of profit and loss manipulation through this method as companies might understate or overstate recognized revenue or expenses to influence perceived company performance.
- Accountants may use the flexibility in revenue and expense recognition to shape financial results, which can distort the actual financial health of a company during a particular accounting period.
Researched and Authored by Kunal Goel | Linkedin
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