What is the Percentage of Completion Method?
The percentage of completion method is a revenue recognition accounting concept that evaluates how to realize revenue periodically over a long-term project or contract. Revenue, expenses, and gross profit are recognized each period based on the percentage of work completed or costs incurred.
Understanding the Percentage of Completion Method
The percentage of completion method of accounting requires the reporting of revenues and expenses on a period-by-period basis, as determined by the percentage of the contract that has been fulfilled. The current income and expenses are compared with the total estimated costs to determine the tax liability for the year.
For example, a project that is 20% complete in year one and 35% complete in year two would only have the incremental 15% of the revenue recognized in the second year. The recognition of income and expenses on this work-in-progress basis applies to the income statement, but the balance sheet is handled the same way as the completed contract method.
There are two main conditions for the use of the percentage of completion method. First, collections by the company must be reasonably assured; second, the company must be able to reasonably estimate costs and the rate of project completion.
Using the percentage of completion formula
There are three ways to determine a project’s percentage of completion. You can figure out POC by using:
- Units, or
- Labor hours.
Costs are used most often, but some contractors may find that units completed or labor hours may more accurately reflect the completion of their projects. The important thing to remember is that you have to be consistent in how you calculate the percent complete.
The percentage of completion formula that is used to calculate how much revenue can be recognized in a period compares the total costs to date with the total estimated costs on the project. The total percentage of costs that have been incurred is the percentage of completion for the project.
Total costs to date ÷ total estimated costs = percent complete
For example, a project that has estimated costs of $100,000 has incurred $50,000 in costs so far. Dividing the costs ($50,000) into total estimated costs ($100,000), gives a percentage of completion of 50%.
$50,000 ÷ $100,000 = 0.5 (50%)
This means half of the total revenue for the project can be recognized. If the contract is for $120,000, $60,000 can be included in the income statement.
The calculation above seems pretty simple. But when change orders are included and estimates change as the project goes along, the calculations can become fairly complicated.
The work in progress report provides a summary of the information used in the percentage of completion calculation. It includes total revised contract amount, total costs to date, percent complete based on cost, amount billed to date, and the difference between the amount billed and the percent of revenue that can be recognized.
When the amount billed to date is more than the revenue that is recognized by the percentage of completion method, that’s called overbilling. Because the contractor has billed more than they should, the overbilling is recorded as a liability on the financial statements.
If the amount billed to date is less than the revenue that is recognized by the percentage of completion method, that’s called underbilling. That amount is recorded as an asset, as more money is due than has been billed.
These differences in the billing amount are recorded as journal entries in the general ledger. They increase or decrease the amount of revenue recognized on the income statement and create an asset or a liability on the balance sheet.
These adjustments ensure that the income shown on the income statement is reflective of the percentage of completion method.
Ways to calculate percentage of completion
The percentage of completion is determined in one of three ways:
The cost-to-cost method compares the total expected costs of a project to the costs incurred to date. To determine the percentage of completion, divide current costs by total costs and multiply by 100. For instance, if a project’s total costs are expected to be $5 million, and the current costs incurred are $2 million, you can divide $2 million by $5 million and multiply by 100. The percentage of completion is 40%.
The efforts-expended method compares the total estimated effort with the effort expended to date. The units used to calculate effort expended may be labor hours, machine hours or amount of materials. The calculation to determine the percentage of completion is the same: divide current effort by total effort and multiply by 100.
For example, if a contractor estimates a project will take 25,000 labor hours, and, to-date, labor hours are at 16,000, you can divide 16,000 by 25,000 and multiply by 100 to determine the project is at 64% completion.
The units-of-delivery method can be used when a project depends on deliveries of specific units. For example, a contractor may be hired to build a 200-home development. The percentage of completion can be determined by comparing the total number of homes (200) to the number of homes finished to date. If the contractor has built 80 homes, the percentage of completion is 40%, or 80 divided by 200, then multiplied by 100.
Potential for Abuse of the Percentage of Completion Method
Percentage of completion method is vulnerable to abuse by unethical companies. Those who wish to engage in creative accounting can easily move around income and expenses from one period to another period, understating or overstating amounts. This game would not be sustainable, however, as Toshiba Corp. discovered in 2015.
The infrastructure unit of the Japanese conglomerate understated operating costs by approximately 152 billion yen ($1.2 billion) between 2008 and 2014. Shortly after the scandal broke, the CEO was forced to resign, and half the Board of Directors stepped down.
How to use the percentage of completion method
The percentage of completion method is used to recognize revenue from a project for a certain time period. Once you determine the percentage of completion, you can use that figure to calculate the revenue earned in the same time period, typically for a quarter or for a year.
Follow these steps to use the percentage of completion method:
- Find the the percentage of completion. Calculate the percentage of completion using the cost-to-cost method, effort-expended method or units-of-delivery method.
- Calculate revenue to date. Multiply the total estimated revenue for the project by the percentage of completion to calculate the revenue that can be recognized to date.
- Determine the revenue for the current period. Subtract any estimated revenue previously accounted for from the to-date revenue. This amount can be recorded as revenue for the current accounting period.
You can calculate project costs using the same method. Multiply total estimated costs by the percentage of completion, and subtract any costs you have already accounted for. You will then have the costs that can be recognized for the current accounting period.
Examples of the Percentage of Completion Method
The percentage of completion accounting method is commonly used by construction firms that are contractors for buildings, energy facilities, public sector infrastructure, and other long-term physical projects. It has also been used by defense contractors (think nuclear submarines or aircraft carriers) and software developers whose projects represent a multi-year commitment of resources. For software developers, the product must be a significant custom-designed project for a client.
Fluor Corporation, a global engineering and construction firm, provides details about its use of the percentage of completion method in its 10-K filing under “Note 1 – Major Accounting Policies” of the notes to the consolidated financial statements. An analyst would learn that changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined by the company.
Income recognized in excess of billed amounts is booked as a current asset under “contract work in progress” and billed amounts to clients in excess of income recognized to date are booked as a current liability under “advance billings on contracts.”