The percentage-of-completion method enables companies to recognize revenue and expenses systematically over the life of long-term construction projects. Rather than waiting until project completion to record all revenue, companies can match revenue recognition to project performance. The percentage of completion method provides a truer financial picture for construction firms with jobs spanning multiple periods. By percent of completion method recognizing revenues and expenses throughout a project, it avoids the lumpiness issues of alternative accounting methods. Under the percentage of completion method, income and expenses are compared to the total estimated costs, allowing for a more accurate determination of the tax liability for each year. When you notice discrepancies, ensure your accountant is aware so they can record them as journal entries.
They also need to adjust for “uninstalled materials,” which have a special definition under the guidance. Companies can recognize revenue for these materials in an amount equal to their cost, using the “zero-profit carve-out method” when they transfer control. ASC 606 gives points of special emphasis when companies use a percentage-of-completion method.
Regardless of the accounting method your construction business is using, it’s important to take steps to secure your payments on every project. Percentage of completion method is vulnerable to abuse by unethical companies. Those who wish to engage in creative accounting can easily move around income and expenses from one period to another period, understating or overstating amounts. This game would not be sustainable, however, as Toshiba Corp. discovered in 2015. The infrastructure unit of the Japanese conglomerate understated operating costs by approximately 152 billion yen ($1.2 billion) between 2008 and 2014.
The effect of this journal is to include an amount equal to the income recognized for the period as a debit to the construction in progress account. The balance on the construction in process account is now the revenue recognized of 1,625 (300 + 450 + 350 + 525) which again represents the cumulative costs plus income recognized to date. The current period costs and current period revenue are balanced with total estimated costs to calculate tax liability for a particular period. Furthermore, if a business seeks outside investors, it can be challenging to prove to them the value of the company during times of little-to-no incoming revenues.
Further, this method is vulnerable to fraud and underreporting of a milestone period, so accounting practices must be closely reviewed. 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.
The ASC 606 standard unifies revenue recognition practices across various industries, while IFRS 15 sets specific criteria for contracts to exist, emphasizing performance, collectability, and measurability criteria. Each method of the percentage of completion method has its specific application depending on the project’s characteristics and contract terms. Accounting professionals must choose the most appropriate percentage of completion method to recognize revenue and comply with applicable accounting standards. This method is best used for projects in which you, as the contractor, must deliver several identical services or end products. In other words, any time the contract can be split into a specific number of identical deliverables, such as identical pieces of furniture, the units-of-delivery method can be used to identify percentage of completion. Although the percentage-of-completion method is complicated, if your estimates are reliable, it can provide more current insight into financial performance on long-term contracts.
Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Suppose we have a dataset of some Students’ Names, Their Obtained Marks in multiple subjects, and their Total Marks. Businesses should weigh the benefits against limitations based on their operations. If your estimates are wildly inaccurate, numbers will skew, resulting in a barrage of adjustments. Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He’s currently a VP at KCK Group, the private equity arm of a middle eastern family office.
Work in progress (WIP) accounting is a method of accounting tailored specifically to construction that tracks costs and revenues throughout the lifecycle of construction projects. 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.
To calculate the percentage of work completed in the current accounting year, subtract the percentage of work completed up to the last accounting period from the cumulative percentage. This approach is most effective when the estimation of project completion stages can be reasonably made or when the remaining costs to complete the project can be estimated. As a result percentage of completion https://adprun.net/ is almost always the best route to take, with two significant exceptions. Progressing through a job can often feel like the last half of a tightly contested NFL game. Using the percentage of completion method, it’s almost as if you have a scoreboard to keep track of all the progress made so far. Each phase of the job is a possession, and the project timeline is like the game clock.
If tax rates were to increase during that period of five years, the company faces paying higher taxes than it would have if reporting occurred sooner in the process. The completed contract method (CCM) of accounting considers all income and expenses directly related to a long-term contract as received when work is completed. The date of completion is spelled out in the contract and is often months or even years away from the date work begins. Therefore, if the project is deemed to be 40% complete, the business would report 40% of the $4 million project revenue ($4 million x 0.4). The firm will also report 40% of the $3 million in expenses ($3 million x 0.4). This calculation will result in a current gross profit of $400,000 ($4 million x 0.4) – ($3 million x 0.4).
The company must be reasonably assured of collections and capable of reasonably estimating costs and the project completion rate. Moreover, contractors won’t have to wait till the end of a project to receive payments. Though a construction company may enjoy a break from taxes during the working phase—and sometimes may even qualify for certain tax incentives in the meantime—this method can be a riskier way to account for operations.
The integrated approach leads to greater efficiency, accuracy and transparency. After final costs and revenues are tallied, closing entries are required to zero out the temporary construction in progress accounts. This enables systematic revenue and expense recognition over the course of the project. The percentage of completion method should be avoided in cases of significant uncertainties about completion percentage or remaining costs.