Percentage of Completion Method

Some types of services (projects) are performed not at once, but over a span of several reporting term. Examples of such projects include the construction of large buildings or other structures by contractors as well as software development. In this case, special rules apply when accounting for proceeds attributable to the reporting term, recognizing expenses that create proceeds, and determining the economic result of the corresponding activities.

The quota of completion method recognizes proceeds and expenses in each term as a project progresses, that is, based on the percentage of work completed. This allows business entities to remain profitable in their book value. The contractor has the right to demand interim payments from the customer, which are proof of participation in the project of the customer.

How percentage of completion method you can use?

There are two main causes put forward by GAAP that determine whether or not a business can recognize the proceeds in the bookkeeping records:

• The income is earned;
• The income is realizable.

If you are doing a long-term project agreement, a portion of the revenue is being earned each year. The business would realize the proceeds by taking a percent completion of the project and turning that into a number of values that you can put on the books at the end of the year.

To be able to do the calculations correctly, the business can not only determine at what stage the task has currently at or had reliable numbers for the total expense it would still need to spend on the task until the realization date. So, if the business cannot be certain about either one, a completed contract method should be used instead.

Nonetheless, the percentage of completion, if applicable, is considered a preferable method for recognizing revenue over multiple years according to GAAP. So, next, we are going to explain possible ways to calculate the revenue using this particular method.

Cost-to-cost calculation approach

The easiest way to calculate how much of the project work has been done is to look at the costs that have been incurred each year and compare that to what the company initially budgeted for when signing a contract. After all, the cost is typically a function of making the money.

So, if you can look at the costs planned for the project and look at the actual expenses and other costs your business has incurred as of today, you can kind of figure out what proportion of the job has been completed. So that’s why it’s called the proportion of completion. Accordingly, you can use that percentage to estimate how much of the total revenue has already been earned.

Example

Let’s see what this would look like in real life. You are a construction company that just signed a contract for a total price of 10 million dollars and estimated costs of 8 million dollars. When the first year comes to an end, you spent $2,500,000 and estimate that it will cost you $5,800,000 more to complete the construction. By the end of Year 2, you spent $6,000,000. Once the construction was completed, you could tell that it actually cost you $8,350,000.

We presented all the numbers in table form for easy reference and understanding. The total costs, here, represent the money you spent as of the date plus the money you expect to spend to deliver the final product. Notice that at the end of the first year, your costs were higher than you initially planned, so your estimated profit was lower compared to what you planned to get when you were signing the contract. However, you managed to get the costs under control the next year and expected to receive even higher profit than initially. Unfortunately, you overestimate your ability to keep the costs down and earn slightly less than expected.

So, what about the revenue you can put on your books each year? You can determine the percent complete for each year by dividing the expenses incurred so far by the total cost. Then, you will multiply the contract price by the interest rate you got for each year. The result is how much incomeyou can record as earned for the year less any revenue you have already recognized. If you did your calculations right, the income for all three years will add up to the contract price ($3,010 + $4,630 + $2,360 = $10,000).

Efforts-expended calculation approach

You would measure the amount of revenue to record as earned based on the percentage of efforts (machine or labor hours, direct materials) that are put in from the start until the current date set against all the efforts expected to be put into the final product. To do the math, you would need to divide the hours/amount of materials/etc. to date on the overall evaluation of the effort.

Example

You are a software development company that has a new contract. The contract price is $26,000 and you expect it will take you 200 hours to complete. So, how would you find how much revenue to put in your accounting record at the end of year one if your developers spent 85 hours working on this specific software?

Well, you will simply divide 85 hours by 200 hours, which will give you 0.425 or 42.5%. This means that you already earned 42.5% of the $26,000 you expect to receive, which is equivalent to $11,050. If you complete the software next year, you can recognize the remaining revenue – $14,950.

Units-of-delivery calculation approach

This approach is probably the simplest because it compares the actual units of goods or services you are delivering to the total number of units you agreed to deliver to the other entity under the terms of the contract. So, if there is no one, cohesive product or service you need to deliver at the end of the project. For example a piece of software or an aircraft, but rather a specific number of copies of exactly the same product or service or a contract is split into distinct deliverables, then you can use this calculation approach to determine income you have earned so far.

For the calculation, you would simply divide the number of units you finished making as of today by the total units you agreed to manufacture. Just a little reminder: when doing a bookkeeping entry, keep in mind that you might have already recognized a portion of that revenue in previous periods, so subtract any amount already on your books.

Example

Your company signed a contract with an airline to manufacture seven new aircraft. The contract price is $1,500 million. Almost a year later, you deliver 2 completed aircraft. How much revenue can your accountant recognize for that year? To compute the proportion value divide 2 by 7. Then, multiply the result (29%) by the contract price to get a revenue of $428.5 million. This is what you can report on your Profit and Loss Statement.

Next year, you will deliver 3 aircraft. So, you should add the 2 aircraft you already finished earlier and then divide 5 by 7 to get a percentage of completion of 0.7143 or 71%. Next, you simply multiply $1,500 by 71% to get the total revenue earned so far – $1,071.5 million. However, you need to find out what number to record in the books for the send year. Simply, subtract what you have on the books before that ($425.5 million) to get about $643 million of revenue earned for the second year.