What Is the Percentage of Completion Method?
Let me explain the percentage of completion method to you—it's a common accounting practice, especially in construction, where you recognize revenue and expenses based on how far along a project is. This differs from the completed contract method, which waits until everything is done before recording the final numbers. By grasping this, you can see how businesses report their finances accurately over the life of long-term contracts.
Key Takeaways
- The percentage of completion method allocates revenues and expenses based on the proportion of work completed on long-term contracts.
- Unlike the completed contract method, this approach allows for income and expense recognition before the project is fully completed.
- Construction firms, defense contractors, and software developers with long-term projects widely use this method.
- The accuracy of revenue recognition under this method depends on reliable cost estimations and assurance of payment.
- The method has potential for manipulation, evidenced by historical cases of financial misreporting.
Exploring How the Percentage of Completion Method Works
You need to report revenues and expenses each period based on the contract's completion percentage with this method. Compare current income and expenses to total estimated costs to figure out your annual tax liability. For example, if a project is 20% complete in year one and 35% in year two, you only recognize the additional 15% revenue in the second year. You recognize income and expenses incrementally on the income statement, while handling the balance sheet just like in the completed contract method.
There are two main conditions you must meet to use this method. First, collections by the company must be reasonably assured; second, the company must be able to reasonably estimate costs and the rate of project completion.
Real-World Applications of the Percentage of Completion Method
You'll find the percentage of completion accounting method commonly used by construction firms handling buildings, energy facilities, public sector infrastructure, and other long-term physical projects. It's also applied by defense contractors—for things like nuclear submarines or aircraft carriers—and software developers on multi-year resource commitments. For software developers, the product has to be a significant custom-designed project for a client.
Take Fluor Corporation, a global engineering and construction firm; in its 10-K filing under 'Note 1 - Major Accounting Policies' in the notes to the consolidated financial statements, it details how it uses this method. As an analyst, you'd learn that changes to total estimated contract costs or losses are recognized in the period they're determined. Income recognized in excess of billed amounts goes as a current asset under 'contract work in progress,' and billed amounts exceeding recognized income are a current liability under 'advance billings on contracts.'
Risks and Ethical Considerations of the Percentage of Completion Method
Be aware that the percentage of completion method is vulnerable to abuse by unethical companies. If someone wants to engage in creative accounting, they can shift income and expenses between periods, understating or overstating amounts. This isn't sustainable, though, as Toshiba Corp. found out in 2015. The infrastructure unit of the Japanese conglomerate understated operating costs by about 152 billion yen ($1.2 billion) from 2008 to 2014. Right after the scandal, the CEO resigned, and half the Board of Directors stepped down.
The Bottom Line
The percentage of completion method is a standard accounting practice for industries with long-term contracts, like construction, giving you a real-time view of revenues and expenses based on project progress. It requires assured payment and reliable estimates of completion stages. While it provides transparency and accuracy in financial reporting, it's open to misuse if not managed properly, as past scandals show. You, as a company or analyst, must apply diligence and integrity to avoid misleading financial statements.
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