Percentage of Completion Method: A Simple Guide for Construction Accounting
The percentage of completion method helps companies track revenue and expenses as construction projects move forward. This approach proves vital for accurate financial reporting in long-term contracts. A construction company building a 10-story office complex with a $4 million contract value can recognize income based on completed work instead of waiting until the project ends.
The percentage of completion method is different by a lot from the completed contract method in construction accounting. Companies using the completed contract method wait to report income and expenses until project completion. This accounting system needs progress invoices to bill clients as work moves forward. The IRS requires contractors to use the percentage of completion method for long-term construction projects.
This detailed guide will help you grasp everything about this crucial accounting method. You will learn how to calculate project completion percentages and implement this method the right way. The guide also shows you when this method makes sense for your specific situation, whether you run a growing construction business or manage contractor finances.
What is the Percentage of Completion Method?
Construction accounting brings unique challenges when dealing with long-term projects. Long-term construction contracts create specific financial reporting complexities that standard accounting approaches don’t deal very well with – from fluctuating material prices to unpredictable delays and complex contract terms.
Definition and purpose
The percentage of completion method (PCM) lets companies recognize revenues and expenses step by step throughout a project’s lifecycle rather than waiting until final completion. This method sees construction as an ongoing process and shows financial results as they happen.
PCM needs three main components to work: the total contract price (agreed-upon customer payment), total estimated costs (projected expenses to complete the contract), and costs incurred to date (actual expenses so far). Companies use these figures to calculate completed work portions and recognize matching percentages of contract revenue.
GAAP and IFRS have backed PCM as their preferred method for construction revenue recognition when companies can make reliable estimates and track progress accurately. On top of that, current standards line up this concept with “over time” revenue recognition for long-term contracts.
How it is different from the completed contract method
PCM and the completed contract method (CCM) show a fundamental difference in their approach to financial reporting. PCM treats construction as a continuous process with ongoing financial recognition. CCM sees each project as one unit measured only at delivery.
These different philosophies affect financial statements in distinct ways:
- PCM: Revenue, expenses, and profits flow steadily through books as work moves forward. Project performance updates come regularly but need accurate progress estimates.
- CCM: All income and expense reporting waits until project completion.
PCM works like a continuous sale where buyers and sellers have enforceable rights. Buyers can set specific performance requirements while sellers can ask for payments based on achieving these requirements.
Companies must meet two key conditions to use PCM:
- Collections by the company need reasonable assurance
- The company should know how to estimate costs and measure progress accurately
Without PCM, recognized revenue would match only the total billed amount for each period. This wouldn’t show the actual work done and would cause incorrect profit swings between reporting periods.
How the Percentage of Completion Method Works
Construction companies need specific calculation techniques and reporting tools to track project progress accurately when they implement the percentage of completion method. They use formulas of all sizes to determine project completion levels and the revenue they can recognize during each reporting period.
Cost-to-cost formula explained
The cost-to-cost method stands as the most accessible approach to calculate completion percentage. This formula compares costs incurred to date against the total estimated costs for the whole project. The simple calculation works like this:
Percentage complete = (Costs incurred to date ÷ Total estimated costs) × 100
To cite an instance, see a construction company that spends $400,000 on a project with estimated costs of $800,000. The project would be 50% complete. The company would recognize $500,000 in revenue if the contract value is $1,000,000 (50% of the total contract price).
Alternative calculation methods: units and labor hours
The cost-to-cost method dominates the field, but two other approaches offer alternatives based on project characteristics:
Units completed method measures completion by comparing physical outputs delivered to total expected outputs. A contractor’s project would be 50% complete after finishing five houses in a contract to build 10 similar houses. This approach excels when deliverables are uniform and measurable.
Efforts-expended method determines completion through labor hours worked or machine hours used. The project reaches 50% completion when workers log 1,200 hours out of an estimated 2,400 total labor hours. This technique proves valuable when labor or machinery usage relates directly to progress.
Role of work-in-progress (WIP) reports
Work-in-progress reports are the foundations of tracking projects that use the percentage of completion method. These reports paint a clear picture of a project’s financial standing and progress. They include several crucial elements:
- Percentage complete: Reveals the project’s progress based on the chosen method
- Earned revenue: Shows revenue recognized based on completion percentage
- Job costs-to-date: Lists all costs incurred on a project
- Estimated costs: Projects total costs needed to complete the work
Construction businesses can spot potential issues early through WIP reports, including cost overruns or project delays. These reports also help determine if a project faces overbilling or underbilling. Overbilling happens when charges exceed earned work value, while underbilling occurs when contractors bill less than what they earned.
Construction companies maintain accurate revenue recognition throughout extended projects by tracking these financial metrics consistently.
When and Why to Use This Method
Businesses need to pick the right accounting method that meets both regulatory rules and their operational needs. The percentage of completion method isn’t optional – regulations often make it mandatory.
IRS and GAAP requirements
The federal tax code makes contractors use the percentage of completion method when handling long-term construction projects. Some exceptions apply though. Smaller contractors that earn $25 million or less in average gross receipts can use different methods ($29 million for 2023 after inflation adjustments). Projects must wrap up within two years to qualify for these exceptions.
Financial reporting rules have evolved from ASC 605 to ASC 606, but GAAP continues to support revenue recognition as companies earn it.
Best fit project types and contractor profiles
Construction companies, defense contractors building submarines or aircraft carriers, and software developers with multi-year projects benefit most from this method. Software projects must be specifically designed for individual clients.
Two key conditions must be met: Companies need reliable payment collection and accurate estimates of costs and completion timelines.
Tax implications and deferral opportunities
Tax deferral options exist even when PCM use is required. Companies can delay gross margin recognition for projects that are less than 10% complete at year-end. This helps preserve cash flow without needing separate election paperwork.
The percentage of completion method usually recognizes income earlier than the completed contract method.
Pros and Cons of the Percentage of Completion Method
The percentage of completion method stands out from other accounting approaches. It brings both great benefits and challenges to construction businesses.
Advantages for cash flow and forecasting
Construction companies can track their project performance in real-time with this method. It creates a steady flow of revenue that helps contractors pay their ongoing expenses. The method boosts cash flow management because revenue matches the completed work. Construction firms can make better financial forecasting decisions about their resources and future investments. This approach matches the natural progression of most construction projects.
Risks of inaccurate estimates
The biggest drawback comes from depending on estimates. Wrong projections can result in billing issues with clients, and companies must spend time fixing revenue calculations. Change orders pose another major risk that can affect project scope, costs, and timelines. Companies need robust cost tracking systems to maintain accuracy. Even small estimation errors can throw off profit reports.
Impact on financial statements
Financial reports become more consistent across accounting periods when revenue spreads throughout a project’s lifecycle. Companies see smoother earnings patterns but must watch their billing carefully. Tax payments might be due before projects end, and financial reporting becomes more detailed. The method gives stakeholders a better view of how projects perform financially.
Conclusion
The percentage of completion method is a vital accounting approach that construction businesses use to manage their long-term projects. This piece shows how companies can recognize revenue and expenses as work progresses instead of waiting until the project ends. This approach helps construction firms maintain accurate financial reporting and better manage their cash flow.
We got into different calculation techniques—cost-to-cost, units completed, and efforts-expended—that determine completion percentages. Work-in-progress reports are the foundations of tracking project status and spotting problems before they grow bigger.
This method gives companies great insights for financial forecasting and steady revenue recognition, but it comes with its share of challenges. Wrong estimates can create billing issues and force financial statement adjustments. Success depends on reliable cost tracking systems and careful projection analysis.
Federal regulations require this approach for long-term construction projects, though smaller contractors may qualify for some exceptions. Companies that use this method end up with a clearer picture of their ongoing financial performance and can make smarter decisions about where to put their resources.
Construction companies and their accountants need to know when and how to use the percentage of completion method correctly. This knowledge helps maintain accurate financial reports and meet regulatory requirements. A construction company’s success relies not just on finishing projects but also on tracking their financial progress at every step.
