Overview of the Percentage of Completion Method
The percentage of completion method calculates the ongoing recognition of revenue and expenses related to longer-term projects based on the proportion of work completed. By doing so, the seller can recognize some gain or loss related to a project in every accounting period in which the project continues to be active. The method works best when it is reasonably possible to estimate the stages of project completion on an ongoing basis, or at least to estimate the remaining costs to complete a project. Conversely, this method should not be used when there are significant uncertainties about the percentage of completion or the remaining costs to be incurred. The estimating abilities of a contractor should be considered sufficient to use the percentage of completion method if it can estimate the minimum total revenue and maximum total cost with sufficient confidence to justify a contract bid.
The ability to create dependable contract estimates may be impaired when there are conditions present that are not normally encountered in the estimating process. Examples of these conditions are when a contract does not appear to be enforceable, there is litigation, or when related properties may be condemned or expropriated. In these situations, use the completed contract method instead.
In essence, the percentage of completion method allows you to recognize as income that percentage of total income that matches the percentage of completion of a project. The percentage of completion may be measured in any of the following ways:
Cost-to-cost method. This is a comparison of the contract cost incurred to date to the total expected contract cost. The cost of items already purchased for a contract but which have not yet been installed should not be included in the determination of the percentage of completion of a project, unless they were specifically produced for the contract. Also, allocate the cost of equipment over the contract period, rather than up-front, unless title to the equipment is being transferred to the customer.
Efforts-expended method. This is the proportion of effort expended to date in comparison to the total effort expected to be expended for the contract. For example, the percentage of completion might be based on direct labor hours, or machine hours, or material quantities.
Units-of-delivery method. This is the percentage of units delivered to the buyer to the total number of units to be delivered under the terms of a contract. It should only be used when the contractor produces a number of units to the specifications of a buyer. The recognition is based on:
For revenue, the contract price of units delivered
For expenses, the costs reasonably allocable to the units delivered
Use the same measurement method for similar types of contracts. Doing so improves the consistency of the percentage of completion results over time.
When the contractor has difficulty deriving the estimated cost to complete a contract, base the recognition of profit on the lowest probable profit, until the profit can be estimated with more accuracy. In cases where it is impractical to estimate any profit, other than to be assured that a loss will not be incurred, assume a zero profit for revenue recognition purposes; this means that revenues and expenses should be recognized in equal amounts until such time as more accurate estimates can be made. This approach is better than the completed contract method, since there is at least some indication of economic activity that spills over into the income statement prior to project completion.
The steps needed for the percentage of completion method are as follows:
Subtract total estimated contract costs from total estimated contract revenues to arrive at the total estimated gross margin.
Measure the extent of progress toward completion, using one of the methods described above.
Multiply total estimated contract revenue by the estimated completion percentage to arrive at the total amount of revenue that can be recognized.
Subtract the contract revenue recognized to date through the preceding period from the total amount of revenue that can be recognized. Recognize the result in the current accounting period.
Calculate the cost of earned revenue in the same manner. This means multiplying the same percentage of completion by the total estimated contract cost, and subtracting the amount of cost already recognized to arrive at the cost of earned revenue to be recognized in the current accounting period.
This method is subject to fraudulent activity, usually to over-estimate the amount of revenue and profit that should be recognized. Detailed documentation of project milestones and completion status can mitigate the possibility of fraud, but cannot eliminate it.
Example of the Percentage of Completion Method
Logger Construction Company is building a maintenance facility on a military base. Logger has thus far accumulated $4,000,000 of costs related to the project, and billed the customer $4,500,000. The estimated gross margin on the project is 20%. Therefore, the total of expenses and estimated gross profit for the project is:
$4,000,000 Expenses ÷ (1 – 0.20 Gross margin) = $5,000,000
Since this figure is higher than the to-date billings of $4,500,000, Logger can recognize additional revenue of $500,000, using the following journal entry:
|Unbilled contract receivables||500,000|
|Contract revenue earned||500,000|
Logger should also recognize a proportional amount of expense to offset the amount of revenue recognized, for which the calculation is:
$500,000 Additional contract revenue × (1 – 0.20 Gross margin) = $400,000