Using Percentage of Completion Method for Revenue Recognition

Introduction

The percentage of completion method is a widely recognized accounting practice for revenue recognition, particularly in industries like construction, engineering, and large-scale manufacturing where projects span over multiple accounting periods. Unlike the completed contract method, which recognizes revenue only upon the project’s completion, the percentage of completion method allocates revenue and expenses based on the project’s progress. This tutorial aims to provide a comprehensive guide on using this method, targeting those with a basic understanding of accounting principles but looking to deepen their knowledge.

What is the Percentage of Completion Method?

The percentage of completion method is an accounting technique used to recognize revenue and expenses proportionally as the work progresses on a long-term project. This method aligns revenue recognition with the actual progress of a project, providing a more accurate reflection of a company’s financial status over time. It ensures that the revenue reported in financial statements corresponds to the work completed and the costs incurred during the period.

Key Concepts

1. Revenue Recognition: The process of recording revenue in the financial statements when it is earned and realizable.
2. Cost-to-Cost Method: A common approach under the percentage of completion method that compares costs incurred to date with total estimated costs to determine the percentage of completion.
3. Output Measures: Alternative methods to the cost-to-cost method, which might include milestones achieved or units produced.

Applicability of the Percentage of Completion Method

Suitable Industries

The percentage of completion method is particularly applicable to industries with long-term contracts, such as:

• Construction: Buildings, infrastructure, and other construction projects.
• Engineering: Large-scale engineering projects, including aerospace, defense, and industrial engineering.
• Software Development: Long-term software contracts where development spans several accounting periods.
• Manufacturing: Custom manufacturing projects with extended production timelines.

Criteria for Application

For a company to use the percentage of completion method, the following criteria must generally be met:

1. Contract Specificity: The contract must be specific regarding the deliverables and payment terms.
2. Reliable Estimates: The company must be able to reasonably estimate the project’s total costs and revenues.
3. Measurement of Progress: The company must have a reliable method to measure the progress towards completion.

Advantages and Disadvantages

Advantages

1. Accurate Revenue Matching: Matches revenue with expenses incurred during the period, providing a more accurate financial picture.
2. Improved Cash Flow Management: Allows for better management of cash flow through consistent revenue recognition.
3. Stakeholder Confidence: Enhances stakeholder confidence by presenting a realistic view of the company’s ongoing projects.

Disadvantages

1. Complexity: Requires detailed tracking and estimation, which can be complex and resource-intensive.
2. Potential for Misestimation: Inaccurate estimates can lead to significant deviations in reported financial outcomes.
3. Compliance and Auditing: Ensuring compliance with accounting standards and passing audits can be challenging.

Steps to Implement the Percentage of Completion Method

Step 1: Identify the Contract

Identify the specific contract that qualifies for the percentage of completion method. Ensure the contract terms are clear, and the scope of work, payment schedule, and deliverables are well-defined.

Step 2: Estimate Total Contract Revenue and Costs

Estimate the total revenue and costs associated with the contract. This includes direct costs (materials, labor, and subcontracting) and indirect costs (overheads). The accuracy of these estimates is crucial for the method’s reliability.

Step 3: Measure Progress Toward Completion

There are two primary methods to measure progress:

1. Cost-to-Cost Method: Compares the costs incurred to date with the total estimated costs to determine the percentage of completion.
2. Output Measures: Uses physical measures of progress, such as units produced or milestones achieved.

Step 4: Calculate Revenue and Expenses

Based on the percentage of completion, calculate the revenue and expenses to be recognized for the period.

Revenue Recognition

Expense Recognition

Step 5: Adjust for Changes in Estimates

Continuously monitor and adjust for any changes in the estimated total costs and revenues. Any changes should be reflected in the calculations to ensure ongoing accuracy.

Step 6: Record Journal Entries

Record the necessary journal entries in the accounting system to reflect the recognized revenue and expenses.

Example Journal Entry

Assume a company has a contract worth $1,000,000 and the total estimated costs are $800,000. If the costs incurred to date are $400,000, the percentage of completion is 50%.

Journal Entry:

• Debit: Construction in Progress (CIP) $500,000
• Credit: Revenue $500,000
• Debit: Cost of Goods Sold (COGS) $400,000
• Credit: Construction in Progress (CIP) $400,000

Step 7: Financial Statement Presentation

Present the recognized revenue, costs, and gross profit in the financial statements. The construction in progress account is reported on the balance sheet under current assets, while the recognized revenue and expenses are reported in the income statement.

Detailed Example

Scenario

Let’s consider a construction company, XYZ Builders, which has a contract to build a commercial complex for $5,000,000. The project is expected to take three years, and the total estimated costs are $4,000,000.

Year 1

• Costs Incurred to Date: $1,000,000
• Estimated Total Costs: $4,000,000
• Total Contract Revenue: $5,000,000

Journal Entries:

• Debit: Construction in Progress (CIP) $1,250,000
• Credit: Revenue $1,250,000
• Debit: Cost of Goods Sold (COGS) $1,000,000
• Credit: Construction in Progress (CIP) $1,000,000

Year 2

• Additional Costs Incurred: $1,500,000
• Total Costs Incurred to Date: $2,500,000

Journal Entries:

• Debit: Construction in Progress (CIP) $1,875,000
• Credit: Revenue $1,875,000
• Debit: Cost of Goods Sold (COGS) $1,500,000
• Credit: Construction in Progress (CIP) $1,500,000

Year 3

• Additional Costs Incurred: $1,500,000
• Total Costs Incurred to Date: $4,000,000

Journal Entries:

• Debit: Construction in Progress (CIP) $1,875,000
• Credit: Revenue $1,875,000
• Debit: Cost of Goods Sold (COGS) $1,500,000
• Credit: Construction in Progress (CIP) $1,500,000

Challenges and Best Practices

Challenges

1. Accurate Estimation: Estimating total costs and revenues accurately is challenging and requires regular updates.
2. Complex Contracts: Managing contracts with multiple deliverables and milestones can be complex.
3. Compliance: Ensuring compliance with accounting standards and regulatory requirements is essential but can be difficult.

Best Practices

1. Regular Updates: Continuously update estimates based on the latest project information to ensure accuracy.
2. Detailed Documentation: Maintain detailed records of all costs incurred and progress measurements.
3. Internal Controls: Implement robust internal controls to monitor project progress and cost management.
4. Professional Judgment: Use professional judgment to assess the reasonableness of estimates and progress measurements.
5. Stakeholder Communication: Regularly communicate with stakeholders about project status and financial implications.

Conclusion

The percentage of completion method for revenue recognition provides a nuanced and accurate way to reflect the financial status of long-term projects. By recognizing revenue and expenses in line with project progress, companies can present a more realistic view of their financial health. However, the method requires meticulous estimation, ongoing monitoring, and robust internal controls to ensure accuracy and compliance.

Implementing this method involves several steps, including identifying the contract, estimating total revenue and costs, measuring progress, calculating and recognizing revenue and expenses, and recording the necessary journal entries. Through detailed examples, we have illustrated how these steps work in practice.

While there are challenges in using the percentage of completion method, following best practices can help mitigate risks and ensure reliable financial reporting. Regular updates, detailed documentation, strong internal controls, professional judgment, and effective stakeholder communication are crucial for successful implementation.

In conclusion, for companies engaged in long-term contracts, mastering the percentage of completion method is essential for accurate revenue recognition and financial reporting. By understanding and applying this method effectively, companies can enhance their financial transparency and stakeholder confidence.