Percentage Of Completion Method

The percentage of completion method is an accounting method for recognizing revenue and expenses for long-term projects that span more than one accounting year. In this method, revenue is recognized every year as a percentage of work completed during that year.

The percentage of completion method is used by the business entities whose business accepts long-term projects where they book the revenue and expenses related to that particular project in more than one accounting year, taking the percentage of the project completed as the criterion or base for recognition of revenue and booking of expenses.

The percentage of completion method of accounting is a procedure for recognizing the revenue and expenses related to projects spanning multiple accounting periods. Industries like real estate’s construction, or manufacturing are some of the examples of such projects.

The recognition of revenue and expense are to the extent of project completion. The main objective of the method is to match the revenue with the corresponding expense incurred as the project progresses.

There are a few steps that are considered in the process. The business has to evaluate the cost and the projected revenue from the investment using percentage of completion method for revenue recognition. That can be obtained based on past data, budgeting, and the type of project. Based on this information, the progress is monitored.

Then the revenue is identified as and when the different stages of the investment is completed. The formula to calculate the revenue is given below.

Revenue for a given year is calculated as follows:

Revenue to be recognized = (Percentage of Work Completed in the given period) * (Total Contract Value)

Here, the biggest challenge is to calculate the percentage of work completed.

. Next, the expenses are also recognized in the same way as the project progresses by multiplying the estimated project cost with percentage of completion.  In this way, the expense is tallied with the revenue.

Next comes the reporting part, where both the revenue and expense is recorded in the profit and loss statement. Any deviation or variation from the calculated or estimated value will impact the financial results. The entire process requires continuous evaluation and monitoring to ensure accuracy. The company has to refer to all supporting documents to justify the same.

To estimate the progress of work or the completion percentage, companies can use either of the three methods:

#1 - Cost Method

In the case of huge projects, the total cost incurred on the project is estimated at the start of the project itself so that the company can accordingly quote a fee for the same. This cost can be the basis for calculating the percentage of completion method as it is assumed that the revenue will go hand-in-hand with the cost incurred.

To determine the percentage of work completed, you can use the following formula:

Percentage of work completed = (Total Expenses incurred on the project till the close of the accounting period) ÷ (Total Estimated Cost of the Contract)

The above formula gives the cumulative percentage of work completed until the close of the accounting period. From this, you need to subtract the percentage of work completed up to the last accounting period to arrive at the percentage of work completed in the current accounting year.

#2 - Efforts Expended Method

This method is similar to the cost method; however, companies can use the efforts involved in completing the project instead of using the cost. The efforts mentioned in this method imply any of the following:

• Direct man-hours that are required to complete the project – This should be used when the project is labor dominated, the major cost is also labor, and the project can be broken down into several person-hours.
• Machine hours required to complete the project – As opposed to the above, machine hours should be used as the basis for the percentage of completion method when the project is automated in nature and requires machinery to complete the project. In this case, the major cost will be attributable to the machinery.
• Material consumed can also be one of the key requirements for the project. In this case, the quantity of material consumed will be the basis.

#3 - The Units-of-Delivery Method

Often, a long-term contract can be split into multiple smaller units delivered to the customer. The price, delivery schedule, units, etc., of each separate unit, are mentioned in the contract.

The revenue recognized under this is not billed to the customer. Revenue recognition, in this case, should be routed to a different account – “Unbilled contract receivables.”

Example 1 (Continued):

Company Roads and Bridges will pass the following journal entries in its books of accounts for revenue recognized under the percentage of completion method for revenue recognition:

Year 1

Year 2

Year 3

Year 4

At the end of the contract, the company will raise an invoice and can then transfer the Unbilled Contract Receivable A/c to Accounts Receivable A/c. Until then, Unbilled Contract Receivable A/c will be shown as an asset on the balance sheet.

If an advance is received towards the contract, the following entry can be passed in the books:

It can be reduced from the Unbilled Contract Receivable A/c while preparing the balance sheet.

Let us look at some suitable examples to understand the concept.

Example #1

A company named Roads & Bridges has won a contract to construct a foot overbridge near a crowded railway station. It has been estimated that the total cost for this project will be $ 10,00,000. The company's policy is to add a margin of 20% to its cost estimate. So the finalized quotation for this project, agreed upon by both the parties, is $ 12,00,000. It is estimated the company will be able to finish the project in 3 years.

The company has incurred the following costs during the life of the project:

• Year 1: $ 1,00,000
• Year 2: $ 3,50,000
• Year 3: $ 4,75,000
• Year 4: $ 1,00,000

Based on the cost method of percentage completion, revenue can be recognized as follows:

If you must have noticed, the revenue recognized exceeds the total project contract value, which was finalized. This is because Roads & Bridges has exceeded the cost by $ 25,000 and revenue is exceed by exactly $ 25,000 + 20% = $ 30,000

However, revenue cannot exceed the contract value as the contractee will not pay any more than $ 12,00,000.

So the key takeaway from the above is that in the last year of the contract, revenue should be recognized only to the extent of the total contract value, and the cumulative completion percentage cannot exceed 100%. Following will be the revised work for the above:

Example #2

ABC Company has won a contract for excavation of an area which will take two years to complete. The excavation has to be done manually as it is an archaeological site on account of which labor cost will be the key cost for completion of the project.

The company has estimated that it will require 50,000 person-hours to complete the work. It has also decided to opt to calculate the percentage of completion by using the efforts expended method.

Total estimated cost for the project = $ 5,00,000

In the above case, the actual person-hours are lesser than the estimated person-hours. As per the percentage of completion method of accounting, the company has to recognize only $ 4,80,000. However, as per the contract, the company will receive $ 5,00,000. So during the last year of the project, the company can recognize the balancing revenue, and the cumulative % of completion should be 100% instead of 96%.

Revised revenue recognition will be as follows:

Example #3

The following is the extract of deliverables of a contract where the contractor is involved in certain activities of construction of business:

From the above, the following is the actual delivery in the financial year Jan 2017 to Dec 2017:

As per the units-of-delivery method of Percentage Completion, the company can recognize $ 46,26,650 as revenue in the given financial year.

One of the basic conservatism principles of accounting is Prudence. This accounting principle requires that a certain degree of caution should be exercised while recording revenue in the books of accounts.

Keeping this principle in mind, the use of a percentage of completion method should be used for booking revenue in the books of accounts only when the following can be assured about the contract:

1. Collections with regards to the contract are assured. To ensure this, companies ask for bank guarantees and performance guarantees from the debtor. They can also check the company's creditworthiness before entering into a contract with them.
2. The company can fairly determine the progress of work done on the contract. It is important because the revenue is directly related to progress. If the progress is incorrect, the revenue presented in the financial statements will be incorrect. There are chances of fraudulent activities if the top management does not properly review this part.
3. Both parties to the contract should be able to fulfill the contractual obligations. The contractor (company recognizing the revenue) should be in a state to complete the project. The contractee (a company that wants the work to be done) should be able to pay and take complete responsibility for the project once the work is completed and the risk is transferred to them.

This method is commonly used for contracts that are for long term involving many accounting periods and where it is possible to estimate the progress of the contract.

• Real estate – this is a sector where every project is for multiple number of years. The building or housing complexes take a long time to complete, and this percentage of completion method for construction contracts is used during the entire project duration. Same is the case for engineering projects or infrastructure development.
• Long term service contracts – In case the business enters into a long term contract which commonly involve software development or installation or maintenance contract, the progress of fulfillment of contact obligation is thoroughly and continuously monitored and accordingly the expense and revenue is recognised.
•  Manufacturing projects – Here the products manufactured takes a long time and this method can be used as and when the completes each stage.

The cases mentioned above are very suitable for using the manufacturing or construction in progress percentage of completion method.

The methods given above are two separate ways to determine the revenues and expenses in any long term contract. However, some differences between them are as follows:

• The revenue is recongnised in case of the percentage of completion method for construction contracts at each stage of completion of the invested project. But in case of the latter the recognition is done only when the project is nearly or fully completed.
• For the former, the expense is also identified in proportion to the completion whereas the latter recognises the expense at completion, not before that.
• Incase of the former, the expenses, after identification, are matched with the revenue, which gives a more accurate result. But in case of the latter, the expense is not matched with the revenue.
• For the former, the reporting is done in the income statement in every accounting period as every step of the project completes. But this is not the case with the latter.  Recognition in the income statement is not done till the entire project is complete.

The choice of the method will depend on many factors like type of investment, the accounting standards applicable or ability to  estimate the progress. But is it necessary to have knowledge about both the methods in details so that manufacturing or construction in progress percentage of completion method can be used in appropriate cases.

This article has been a guide to what is Percentage Of Completion Method. We explain journal entries and how to calculate it along with examples. You may learn more about accounting basics from the following articles –

• Margin of Error
• Percent Error Formula
• Mark to Market Accounting
• Cash Basis Accounting