Definition
The Percentage of Completion Method is an accounting method used in long-term construction projects, where revenue and expenses are recognized progressively based on the project’s stage of completion. This method calculates the revenue and costs associated with a specific reporting period as a portion of the total expected project costs and revenue. It aims to provide a more accurate reflection of a company’s financial position and performance during ongoing, large-scale projects.
Phonetic
The phonetic pronunciation of the keyword “Percentage of Completion Method” would be:pərˈsɛntɪdʒ əv kəmˈpliʃən ˈmɛθəd
Key Takeaways
- 1. Revenue Recognition: The Percentage of Completion Method is an accounting approach to recognize revenue and expenses proportionately over the life of a long-term contract. It ensures that a company’s financial statements provide an accurate representation of the project’s progress and financial health throughout the duration of the contract.
- 2. Calculation: The method calculates the percentage of a project’s completion by dividing the costs incurred during the reporting period by the estimated total cost of the project. This percentage is then applied to the total expected revenue to determine the amount of revenue to be recorded for the period. Additionally, any expenses incurred during the reporting period will also be recognized.
- 3. Applicability: The Percentage of Completion Method is best suited for long-term projects and contracts, particularly in industries like construction, engineering, or software development. It is most useful when there are relatively reliable estimates of the project’s total cost and completion schedule. However, if these estimates are uncertain, the method might not provide an accurate representation of the project’s progress and financial health.
Importance
The Percentage of Completion Method is an important principle in business and finance because it allows companies, especially those in construction or projects that extends over multiple accounting periods, to accurately account for and recognize their revenues and expenses over time. Instead of recognizing all costs and revenues only upon project completion, this method proportionally recognizes them in correlation with the stages of the project’s completion. This approach promotes transparency and presents a healthier and more accurate financial picture of the company’s earnings, allowing investors, creditors, and management to make more informed decisions based on its financial status. It also aids in more effective tax and cash flow planning throughout the course of the project.
Explanation
The Percentage of Completion Method serves a significant purpose in financial accounting, particularly in industries where long-term contracts are commonplace, such as the construction or manufacturing industries. This method aids in measuring the degree of work completed on a project versus the total project scope, as time progresses. It’s a way to recognize revenues gradually over time as the project advances, rather than waiting until the project is entirely completed to recognize revenue. This can provide a more accurate reflection of a company’s financial health and progress in any given accounting period.
The primary usage of the Percentage of Completion Method is to help businesses properly match revenues with expenses that are incurred in the same period. It helps in preventing ‘lumpy’ financial results, where all revenue and costs are recognized only in the period where the project is completed completely. This ability to spread out revenue recognition over the life of a project can have a smoothing effect on a company’s financials, leading to a better understanding of the company’s profitability during the life of the project and not just at its conclusion.
Examples
1. Construction Industry: The Percentage of Completion Method is extensively used in the construction industry. For example, a construction company has been awarded a contract to build a commercial complex. The total contract value is $10 million, and the company expects the project to be completed in 2 years. After the first year, the company has incurred costs of $4 million and anticipates further costs of $3 million to complete the project. So, the percentage of completion at the end of the first year would be 57.14% (4 million/7 million). Based on this percentage, the company would recognize $5.71 million (57.14% of 10 million) as revenue in its income statement for the first year.
2. Aerospace Industry: A company in the aerospace industry might use the percentage of completion method for long-term contracts, such as manufacturing aircraft. Suppose a company has a contract of $200 million to build 10 aircraft over 4 years. At the end of the first year, the company has built and delivered 2 aircraft, having incurred associated costs of $30 million. Considering total estimated costs to be $160 million, the percentage of completion would be 18.75% (30 million/160 million). Subsequently, the company would recognize $37.5 million (18.75% of 200 million) as revenue for the first year.
3. Software Development: In the software industry, a firm may use the percentage of completion method for recognizing revenue on large, long-term projects. For example, a software development company has a contract worth $1 million to develop a custom software solution to be completed in 18 months. At the end of 9 months, they have incurred $350,000 in costs and estimates an additional cost of $150,000 to complete the project. Calculating the percentage of completion (350,000/500,000), results in 70%. This means the company would recognize $700,000 (70% of 1 million) as revenue in the first 9 months.
Frequently Asked Questions(FAQ)
What is the Percentage of Completion Method?
The Percentage of Completion Method is a financial accounting technique used by businesses to recognize revenue and expenses related to long-term projects. It involves calculating the percentage of project completion and recognizing revenue based on this percentage, irrespective of whether or not payment has been made.
How is the Percentage of Completion Method applied in accounting?
The percentage of completion is estimated based on costs incurred in relation to the total estimated costs of the project. The revenue is recognized by multiplying the total contract revenue by the completion percentage then subtracting any revenue already recognized in previous periods.
When is the Percentage of Completion Method used?
This method is typically used in long-term projects like construction, manufacturing, and service-based contracts where progress can be measured and costs can be estimated reliably.
What is the benefit of using the Percentage of Completion Method?
The major benefit of using this method is that it allows businesses to recognize revenue in periods when the associated costs of earning that revenue are incurred, providing a more accurate reflection of financial performance.
What potential challenges can occur with the Percentage of Completion Method?
Since revenue recognition under this method relies on estimations, errors can occur if projected costs change or if the project completion percentage is inaccurately estimated.
How does the Percentage of Completion Method differ from the Completed Contract Method?
While the Percentage of Completion Method recognizes revenue throughout the duration of a project, the Completed Contract Method only recognizes revenue once the project is fully finalized.
What kind of businesses commonly use the Percentage of Completion Method?
Businesses that have long-term contracts such as construction, software development, and aerospace and defense companies typically use this method.
Is the Percentage of Completion Method compliant with GAAP and IFRS?
Yes, this method is compliant and commonly used under both the US Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).
Related Finance Terms
- Contract Revenue: The total revenue that will be earned from a contract, which is often estimated at the beginning of the project.
- Progress Billing: A billing method where the company invoices the customer for the percentage of the work that has been completed.
- Estimated Total Costs: The forecast of overall costs that will be incurred over the course of the project.
- Costs Incurred to Date: The costs that have been spent on the project up until the current point in time.
- Recognized Revenue: The portion of the total contract revenue that can be recognized as revenue in the financial statements, based on the percentage of the project that has been completed.
