The percentage of completion method evaluates work-in-progress that’s applied to long-term projects, in which expenses and revenues are recorded as a percentage of the completed work during that period.
By doing this, the contractor or seller can record some losses or gains for certain projects within the financial year or accounting period in which the project remains active. The percentage of completion method is a contrast to the completed contract method, which measures and records expenses and revenue at the end of the project.
This method is common in the construction industry for energy infrastructure and public sector infrastructure. Generally, it is used in long-term physical projects. Examples of such common projects could include: building a refinery, dam, or state-building.
The percentage of completion system is used when revenues are determined based on the cost of the project incurred so far. It works best when you can estimate the costs attached to the different stages of completion on an ongoing basis.
When Do We Use the Percentage of Completion Method?
Use the percentage of completion method when:
- A project is expected to take at least two years from the date the contract starts.
- Revenue collection is assured, and estimating project completion is straightforward.
- The system of accounting can reasonably estimate profitability and measure completion progress.
In conditions where litigation exists, where the contract looks unenforceable, or issues exist with some of the properties related to the project or contract, do not use the percentage of completion method. In such situations, use the completed contract method instead.
Ways to Calculate the Percentage of Completion Method
The percentage of completion can be calculated in three ways.
- Cost-to-cost method
- Units-of-delivery method
- Efforts expended method
Cost-to-Cost Method
To use the Cost-to-cost method, you compare the cost of the contract at the calculation period to the total expected contract cost. You do not include the cost of items that have not been installed even if they have been purchased for the contract unless they were specifically manufactured or produced for that contract.
Also, don’t allocate the cost of equipment up-front (as a whole) but over the contract duration.
Units-of-Delivery method
Here, you calculate the proportion of the units delivered to the total number of units based on the buyer’s specifications. For expenses, you calculate the accrued cost for the units delivered, and for revenue, you record the price of the units delivered according to the contract.
Efforts Expended Method
In this method, you compare the calculated percentage of effort expended to date to the total estimated effort to be expended for the duration of the contract. Some of the indices used to measure the percentage of cost with this method are the number of materials, machine hours, and man-hours.
However, of these three methods, the most commonly used is the Cost-to-Cost method.
How to Use the Percentage of Completion
For example, K.K & Sons Construction Company is building a Gas-fired Steam Power Plant, has an estimated eight million dollars ($8,000,000) in project-related costs and the total estimated contract revenue is ten million dollars ($10,000,000).
A cost of six million dollars ($6,000,000) has been incurred to date and a bill of five million dollars ($5,000,000) was issued to the client the previous year.
To apply the percentage of completion method, follow these steps:
Step 1
Calculate the total estimated gross margin (if needed). The gross margin is the net revenue minus the cost of goods. We calculate this by subtracting the total estimated contract costs from the total estimated contract revenues for the project.
Gross margin = $10,000,000 – $8,000,000/ ($10,000,000) = 0.2
The gross margin here is 0.2 or 20%
Step 2
Using the cost-to-cost method, the units-of-delivery method, or the efforts expended method, measure the extent of progress toward completion. In this example, we use the cost-to-cost method. This means calculating the percentage completed by finding the proportion of cost incurred to date to the estimated total cost.
Percentage Complete = $6,000,000/$8,000,000 = 0.75
The percentage of the project that has been completed is 75%
Step 3
Then, we multiply our contract revenue by the estimated completion percentage. This gives us the total amount of revenue that can be recognized.
Total estimated contract revenue = 0.75 * $10,000,000 = $7,500,000
Step 4
Next, we subtract the contract revenue recognized to date through the prior period from the recognized revenue to obtain the result in the present accounting period.
Revenue = $7,500,000 – $5,000,0000 = $2,500,000
Note that in the first year, the previously recognized revenue is zero.
Step 5
Finally, we calculate the cost of earned revenue in the same manner. This means multiplying the percentage of completion by the total estimated contract cost and subtracting the previously recognized cost to arrive at the cost of earned revenue for the present accounting period.
One glaring disadvantage of the percentage of completion method is that it can be easily abused. Companies or accountants that do not adhere to proper ethical standards can choose to transfer expenses or income between different periods, thereby understating or overstating different values to boost short term results.
This is a fraudulent act with serious consequences. But it can be checked or mitigated by having detailed documentation of project sequence, milestones, and delivery dates. And having a good internal and external financial audit system can effectively mitigate this challenge.
FAQs
1. What is the percentage of completion method?
The percentage-of-completion method recognizes revenues and expenses on long-term contracts as a percentage of the work performed during the period.
2. How do you calculate percentage of completion?
To determine the percentage of completion for a project, divide current costs by total costs, and multiply by 100.
3. Does GAAP require percentage of completion method?
GAAP (Generally Accepted Accounting Principles) and the Internal Revenue Service (IRS) do not agree on all aspects of the percentage of completion method of accounting.
4. Who must use percentage of completion method for tax purposes?
Under Sec. 460, taxpayers with long-term construction contracts must generally use the percentage-of-completion method to determine their reportable income.
5. Which method is the better one, the percentage of completion method or the completed contract method?
The percentage-of-completion method is the more commonly used approach and is appropriate in many situations. The completed-contract method is rare but can be useful when the percentage-of-completion method is not applicable.
