Accounting for income and expenses can present a real challenge for construction businesses. When should contractors put revenue on their income statement — when they finish each phase of the project they’re billing for? When the project is complete? Or after the check is in the bank? The percentage of completion method (POC) is one of the most common approaches in construction accounting. Here, we’ll explain how the POC method works, break down the formula, and give you some real-life examples.
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Contractors recognize revenue differently
Suppliers and service providers recognize their revenue as soon as a sale is made. Contractors, however, have a more complicated revenue stream. Many projects last several months, or even years. Contractors have two choices: recognize the income at the end of the project or recognize it as the project progresses.
Waiting until the end of a project makes the accounting easier but means that a contractor’s income will seem unsteady and irregular, since projects end at different times. A contractor may go a month or two with no projects ending, meaning they essentially have no income to report.
Recognizing income as a project progresses makes more sense for long-term contracts and maintains a steady income flow. Most contractors choose to use this method, known as the percentage of completion method. We’ll take a more detailed look at it, including what it is, how it’s used, and mistakes to avoid.
What is the percentage of completion method?
The percentage of completion method is a way of recognizing construction revenue that’s based on the amount of work complete on long contracts. It recognizes project income as the project progresses, usually on a monthly basis.
To calculate the percentage of completion for a project, there are three indicators contractors can use. The most common is costs incurred to date, but they can also use units completed or labor hours. We’ll go into more detail about this calculation later.
Once the contractor has determined the percentage of completion for a project, the percent is multiplied by the total expected revenue. The answer is the amount of income that can be recognized on the project to date. This income is recognized on the income statement through the work in progress report.
Percentage of completion vs. completed contract
Another way contractors can recognize revenue is called the completed contract method. This method only recognizes revenue and costs for projects once they are completed. It’s usually used in the residential sector and on small projects of short duration.
The IRS requires contractors to use percentage of completion for long-term construction projects. The only exceptions are for home construction and small contractors. The small contractor contract exception depends on two conditions: the size of the project and the size of the contractor.
The IRS defines small contracts as those that will be completed within two years. It defines small contractors as those with gross receipts not over $25 million in the previous three years. Both of these conditions must be met to use the completed contract method.
Generally accepted accounting principles (GAAP) require that revenue be recognized in the period it was earned. This means for most long-term projects, the percentage of completion method should be used.
International Financial Reporting Standards (IFRS 15) provides guidance on the treatment of stored materials in income recognition. Stored materials don’t represent completed work, so they have to be treated differently.
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.
Mistakes to avoid when using percentage of completion
Because income recognition is based on a percent of the revised contract for each project, it’s imperative that change orders are entered into the system as soon as they are approved.
If work has been added to a project and not been entered into the accounting software, the project may appear to be overbilled based on the percentage of costs.
Making sure contract amounts and estimates are accurate on the work in progress report ensures income is reported correctly and avoids penalties for overbillings.
Overbilling a project to increase cash flow reduces the amount of income the company records for that period. Income will be reduced by the amount of overbilling. If a company consistently overbills, they will have trouble covering costs as projects are completed. There won’t be enough left in the contract balance to cover the costs at the end of the project. The best bet is to bill the correct percentage of completion and look at other ways to improve cash flow.
Underbilling projects isn’t a good practice either. Reducing the amount billed means you may not be able to cover expenses for the period, causing cash flow problems. The best practice is to bill at the correct percentage of completion.
Remember: Revenue recognition doesn’t equal payment
Most commercial contractors, both general contractors and subcontractors, use the percentage of completion method to report their income. When most of your projects last at least a few months, it’s the most accurate way to recognize revenue.
Of course, reporting income means nothing if you aren’t collecting payments. Cash can only flow out of your business if it’s also flowing in. Regardless of the accounting method your construction business is using, it’s important to take steps to secure your payments on every project.
Using percent complete income recognition requires some specific data that can be difficult to gather if you aren’t using construction accounting software. If your company is looking to transition to percentage of completion revenue recognition, consider changing to a software package that supports it. It’ll save you money over the long haul.