What is Percentage of Completion Accounting?

Accounting for income and expenses can present a real challenge for contractors, especially on long-term projects. The percentage of completion method is one of the most common methods of accounting used in construction. In this article, we’ll explain the percentage of completion method, how it works, and give you some real-life examples.

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What is the percentage of completion method?

Percentage of completion is a method of accounting for long-term projects in which revenue and expenses are recognized based on the percentage of work they have completed during the period. Under percentage of completion, a contractor recognizes project income and expenses as the project progresses, usually on a monthly basis.

In contrast with percentage of completion, the completed contract method is used to recognize project revenue and costs only when the contract is complete. The completed contract method is usually used in the residential sector and on small projects of short duration.

Learn more: What does it mean to “recognize revenue”?

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.

The cost-to-cost formula: How to calculate percentage of completion

The most common way to determine a project’s percentage of completion is by comparing estimated and actual project costs, known as the “cost-to-cost” method:  

Percent complete = Total costs to date ÷ total estimated costs

The total percentage of costs that have been incurred is the percentage of completion for the project. This percentage is multiplied by the total contract amount to determine the revenue to recognize during the period. 

Revenue recognized = Percent complete x contract amount

Instead of costs, percentage of completion can also be calculated using units or labor hours, depending on the nature of the business. The important thing to remember is that contractors must be consistent in how they calculate the percent complete.

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.

Percentage of completion example

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), you find that the project is 50% complete. 

Percent complete: $50,000 ÷ $100,000 = 0.5 (50%)

This means the contractor can recognize half of the total revenue for the project. If the contract is for $120,000, the contractor would record revenue of $60,000 for the period, which would be reflected in their income statement.

Revenue recognized: $120,000 x 50% = $60,000

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IRS requirements

The IRS generally 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, and 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.

Risks with the percentage of completion method

The percentage of completion method is an internal accounting process that can differ from the reality on the jobsite. This can present challenges when the revenue and expenses recognized are different from the actual amounts billed or spent on the project. This can create cash flow problems for the contractor if they aren’t careful. 

Overbilling & underbilling

When the amount billed to date is more than the revenue that is recognized by the percentage of completion method, that’s called overbilling. If a company consistently overbills, they will have trouble covering remaining costs as the project continues. 

Underbilling is the opposite scenario, when the amount billed to date is less than the recognized revenue. 

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.

Change orders

Project expenses never exactly equal the estimated costs. When using the percentage of completion method, it’s important for contractors to revise their estimates anytime changes occur on the job. This ensures the accuracy of their accounting calculations, and helps to avoid cash flow challenges. 

When change orders are included and estimates change as the project goes along, calculating the percentage complete can get complicated. Because income recognition is based on a percent of the revised contract for each project, it’s important that contractors enter change orders into the system as soon as they are approved.

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.

Read more: 7 Construction Accounting Software Platforms for Contractors

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