22 Apr Demystifying the Percentage-of-Completion Method
Long-term projects usually require a different approach to recognizing revenues called the ‘percentage-of-completion’ method. It is used by homebuilders, developers, creative agencies, engineering firms, and many other types of companies. Here is how it works.
Contracts that last for more than one calendar year can be reported two ways:
- The completed contract method. It records revenues and expenses upon completion of the contract terms.
- The percentage-of-completion method. It ties revenue recognition to the incurrence of job costs.
GAAP generally prescribes the latter method, as long as you can make estimates that are ‘sufficiently dependable.’ Most companies with long-term contracts also must use this method for federal income tax purposes. (An exception is permitted for companies with less than $10 million in annual revenues.)
Companies typically compare the actual costs incurred to expected total costs to estimate percentage complete. Alternatively, some may opt to estimate the percentage complete with an annual completion factor. To support this technique, the IRS requires detailed documentation.
Balance sheet effect
The percentage-of-completion method can also impact your balance sheet. Suppose you are working on a $1 million, two-year project. You incur half of the expected costs in year one ($400,000) and bill the customer $450,000. From a cash perspective, it seems like you are $50,000 ahead because you have collected more than the costs you have incurred. However, you have actually underbilled based on the percentage of costs incurred.
Therefore, at the end of year one, you would report $500,000 in revenues, $400,000 in costs, and an asset for costs in excess of billings of $50,000. If you had billed the customer $550,000, however, you would report a $50,000 liability for billings in excess of costs.
This method necessitates subjective estimates about expected costs. It is further complicated by job cost allocation policies, change orders, changes in estimates, and differences between book and tax accounting methods. Contact us for help training your staff on how this method works — or we can perform the analysis for you.