Key takeaways
– The percentage of completion method (POC) recognizes revenue and associated expenses over the life of a long‑term contract in proportion to the contract’s progress toward completion.
– Two main conditions must be met: (1) collectibility must be reasonably assured and (2) the contractor must be able to make reliable estimates of total contract costs and completion.
– Common measurement approaches include cost‑to‑cost (most used), efforts‑expended, and units‑of‑delivery.
– POC gives more timely financial information than the completed‑contract method but requires judgment and strong controls; it is vulnerable to manipulation if estimates or timing are misstated.
(Source: Investopedia/Tara Anand; company disclosures such as Fluor’s 10‑K; historical scandals such as Toshiba’s understatement of costs illustrate the risk.)
How the percentage of completion method works (concept and formulas)
– Basic idea: recognize revenue (and profit) to date in proportion to the fraction of the work completed.
– Common formula (cost‑to‑cost): Percent complete = Costs incurred to date / Estimated total contract costs.
– Revenue to recognize to date = Contract price × Percent complete.
– Revenue to recognize in reporting period = Revenue to date − Revenue previously recognized.
– Profit to recognize in period = (Contract price − Estimated total costs) × Percent complete − Profit previously recognized (or simply revenue recognized in period − costs incurred in period).
– If estimated total costs exceed the contract price, recognize the full expected loss immediately.
Three common ways to measure progress
1. Cost‑to‑cost (input method): costs incurred / total estimated costs. Widely used and accepted under US GAAP for many construction and long‑term contracts.
2. Efforts‑expended (input method): e.g., labor hours or machine hours incurred / total estimated hours. Appropriate when efforts are a true driver of progress.
3. Units‑of‑delivery or milestones (output methods): physical units delivered or contract milestones achieved / total units or milestones. Useful when outputs can be measured directly.
Practical step‑by‑step guide to applying POC
1. Confirm eligibility
– Ensure collectibility is reasonably assured.
– Verify that total contract costs and progress can be reasonably estimated. If not, consider the completed‑contract method (or IFRS guidance under IFRS 15 for performance obligations).
2. Choose a progress measurement method
– Select cost‑to‑cost, efforts‑expended, or an appropriate output measure. Document rationale.
3. Estimate total contract costs and contract revenue
– Include all expected costs (direct labor, materials, subcontractors, allocated overhead, change orders, warranty/retention estimates). Update estimates each period.
4. Compute percent complete and revenue to recognize
– Apply the formulas above to compute revenue and profit to date and for the period.
5. Record costs, revenue, billings and receipts (typical accounting mechanics)
– Record costs as incurred: Dr Construction in Progress (CIP) (asset) ; Cr Cash/AP (liability).
– To recognize revenue (simplified common approach): Dr Accounts Receivable (or Contract Receivable) ; Cr Revenue (for amount recognized this period).
– To move costs to expense: Dr Cost of Goods Sold (COGS) ; Cr CIP (for costs recognized).
– To record billings: Dr Accounts Receivable ; Cr Progress Billings (contra‑asset or liability, depending on presentation).
– Cash collections: Dr Cash ; Cr Accounts Receivable.
– Presentation: CIP less Progress Billings = net asset (“costs and estimated earnings in excess of billings”) or net liability (“billings in excess of costs and estimated earnings”).
(Note: companies use different ledger account names—follow your entity’s accounting policy and auditor guidance.)
6. Handle changes and loss contracts
– Update total estimated costs and profit each period; recognize the effect in the period the change is determined.
– If total estimated costs > contract price, recognize the entire anticipated loss immediately as an expense.
7. Disclose required information
– Describe the accounting policy for long‑term contracts, methods used to measure progress, total contract balances (costs and estimated earnings in excess of billings; billings in excess of costs and estimated earnings), and significant judgments and changes in estimates. Public companies must follow disclosure rules in GAAP/IFRS.
8. Maintain controls and documentation
– Keep supporting schedules for cost accumulations, estimates, change orders, work inspections, and management sign‑offs. Independent review of estimates and periodic external audits reduce risk of error or manipulation.
Example (simple numeric illustration)
– Contract price: $10,000,000
– Estimated total cost: $7,000,000
– Costs incurred to date: $2,000,000
Compute:
– Percent complete = 2,000,000 / 7,000,000 = 28.571%
– Revenue to date = $10,000,000 × 28.571% = $2,857,143
– Profit to date = Revenue to date − Costs to date = $2,857,143 − $2,000,000 = $857,143
Typical journal entries (simplified)
1. To record costs incurred:
– Dr Construction in Progress (CIP) $2,000,000
– Cr Cash / Accounts Payable $2,000,000
2. To recognize revenue for the period:
– Dr Accounts Receivable (or Contract Receivable) $2,857,143
– Cr Revenue $2,857,143
3. To recognize cost of sales for the period:
– Dr Cost of Goods Sold $2,000,000
– Cr Construction in Progress $2,000,000
4. To bill customer (if billed for some amount):
– Dr Accounts Receivable $BilledAmount
– Cr Progress Billings (contra‑asset or liability) $BilledAmount
Real‑world applications
– Construction companies (buildings, bridges, roads, energy facilities).
– Engineering and industrial contractors (large, multi‑year projects).
– Defense contractors for long lead‑time platforms (ships, aircraft) where costs and progress can be estimated.
– Certain custom software development projects (significant, client‑specific, multi‑period work).
– Large manufacturers with long delivery schedules sometimes use a form of POC.
Risks, ethical considerations, and controls
– Judgment intensity: POC relies on estimates of costs and percent complete; management bias or pressure can lead to premature or inflated revenue recognition.
– Earnings management risk: smoothing or accelerating revenue via optimistic cost estimates or reclassifying costs can distort reported performance. Historical scandals (e.g., Toshiba’s infrastructure unit understating costs) show consequences: restatements, leadership changes, regulatory scrutiny.
– Key controls to mitigate risk:
– Segregation of duties and written policies for estimating costs and recognizing revenue.
– Independent, periodic review of estimates (internal audit or external experts).
– Detailed documentation: timesheets, vendor invoices, change order approvals, progress reports, site inspections.
– Conservative reserve setting and prompt recognition of anticipated losses.
– Transparent disclosures to users of financial statements and proactive communication with auditors.
– Board/compensation structures that minimize perverse incentives to manipulate timing.
Tax and regulatory notes
– Tax treatment varies by jurisdiction. In some jurisdictions (including cases under U.S. tax law), long‑term contractors may be required or permitted to use the percentage‑of‑completion method for tax reporting; exceptions exist for small contractors or certain types of contracts. Check local tax rules and consult tax counsel.
– Under U.S. GAAP and IFRS, revenue‑recognition rules require measurement of performance and appropriate disclosure—follow ASC 606 (U.S. GAAP) or IFRS 15 guidance on recognizing revenue over time when performance obligations are satisfied over time.
Disclosure best practices for transparency
– State the method used to measure progress (cost‑to‑cost, efforts expended, output).
– Reconcile beginning and ending contract asset/liability balances (CIP vs. progress billings).
– Disclose significant judgments, changes in estimates, and any material losses recognized during the period.
– Explain major contracts and their expected completion dates when material to the business.
The bottom line
The percentage of completion method provides timely and economically meaningful recognition of revenue and profits for long‑term contracts, reflecting performance as work progresses. It improves comparability and reporting relevance versus the completed‑contract method but depends on reliable estimates and strong controls. Companies should adopt robust estimation processes, transparent disclosures, and independent oversight to minimize the risk of error or manipulation.
Sources
– Investopedia: “Percentage of Completion Method” (Tara Anand). https://www.investopedia.com/terms/p/percentage-of-completion-method.asp
– Public company disclosures (example): Fluor Corporation Form 10‑K, Note on major accounting policies (re: percentage of completion policies).
– Public reporting on accounting scandals (e.g., Toshiba infrastructure unit cost understatement, 2008–2014).
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.
,
What Is the Percentage of Completion Method?
Key takeaways
– The percentage of completion method (POC) recognizes revenue and associated expenses over the life of a long‑term contract in proportion to the contract’s progress toward completion.
– Two main conditions must be met: (1) collectibility must be reasonably assured and (2) the contractor must be able to make reliable estimates of total contract costs and completion.
– Common measurement approaches include cost‑to‑cost (most used), efforts‑expended, and units‑of‑delivery.
– POC gives more timely financial information than the completed‑contract method but requires judgment and strong controls; it is vulnerable to manipulation if estimates or timing are misstated.
(Source: Investopedia/Tara Anand; company disclosures such as Fluor’s 10‑K; historical scandals such as Toshiba’s understatement of costs illustrate the risk.)
How the percentage of completion method works (concept and formulas)
– Basic idea: recognize revenue (and profit) to date in proportion to the fraction of the work completed.
– Common formula (cost‑to‑cost): Percent complete = Costs incurred to date / Estimated total contract costs.
– Revenue to recognize to date = Contract price × Percent complete.
– Revenue to recognize in reporting period = Revenue to date − Revenue previously recognized.
– Profit to recognize in period = (Contract price − Estimated total costs) × Percent complete − Profit previously recognized (or simply revenue recognized in period − costs incurred in period).
– If estimated total costs exceed the contract price, recognize the full expected loss immediately.
Three common ways to measure progress
1. Cost‑to‑cost (input method): costs incurred / total estimated costs. Widely used and accepted under US GAAP for many construction and long‑term contracts.
2. Efforts‑expended (input method): e.g., labor hours or machine hours incurred / total estimated hours. Appropriate when efforts are a true driver of progress.
3. Units‑of‑delivery or milestones (output methods): physical units delivered or contract milestones achieved / total units or milestones. Useful when outputs can be measured directly.
Practical step‑by‑step guide to applying POC
1. Confirm eligibility
– Ensure collectibility is reasonably assured.
– Verify that total contract costs and progress can be reasonably estimated. If not, consider the completed‑contract method (or IFRS guidance under IFRS 15 for performance obligations).
2. Choose a progress measurement method
– Select cost‑to‑cost, efforts‑expended, or an appropriate output measure. Document rationale.
3. Estimate total contract costs and contract revenue
– Include all expected costs (direct labor, materials, subcontractors, allocated overhead, change orders, warranty/retention estimates). Update estimates each period.
4. Compute percent complete and revenue to recognize
– Apply the formulas above to compute revenue and profit to date and for the period.
5. Record costs, revenue, billings and receipts (typical accounting mechanics)
– Record costs as incurred: Dr Construction in Progress (CIP) (asset) ; Cr Cash/AP (liability).
– To recognize revenue (simplified common approach): Dr Accounts Receivable (or Contract Receivable) ; Cr Revenue (for amount recognized this period).
– To move costs to expense: Dr Cost of Goods Sold (COGS) ; Cr CIP (for costs recognized).
– To record billings: Dr Accounts Receivable ; Cr Progress Billings (contra‑asset or liability, depending on presentation).
– Cash collections: Dr Cash ; Cr Accounts Receivable.
– Presentation: CIP less Progress Billings = net asset (“costs and estimated earnings in excess of billings”) or net liability (“billings in excess of costs and estimated earnings”).
(Note: companies use different ledger account names—follow your entity’s accounting policy and auditor guidance.)
6. Handle changes and loss contracts
– Update total estimated costs and profit each period; recognize the effect in the period the change is determined.
– If total estimated costs > contract price, recognize the entire anticipated loss immediately as an expense.
7. Disclose required information
– Describe the accounting policy for long‑term contracts, methods used to measure progress, total contract balances (costs and estimated earnings in excess of billings; billings in excess of costs and estimated earnings), and significant judgments and changes in estimates. Public companies must follow disclosure rules in GAAP/IFRS.
8. Maintain controls and documentation
– Keep supporting schedules for cost accumulations, estimates, change orders, work inspections, and management sign‑offs. Independent review of estimates and periodic external audits reduce risk of error or manipulation.
Example (simple numeric illustration)
– Contract price: $10,000,000
– Estimated total cost: $7,000,000
– Costs incurred to date: $2,000,000
Compute:
– Percent complete = 2,000,000 / 7,000,000 = 28.571%
– Revenue to date = $10,000,000 × 28.571% = $2,857,143
– Profit to date = Revenue to date − Costs to date = $2,857,143 − $2,000,000 = $857,143
Typical journal entries (simplified)
1. To record costs incurred:
– Dr Construction in Progress (CIP) $2,000,000
– Cr Cash / Accounts Payable $2,000,000
2. To recognize revenue for the period:
– Dr Accounts Receivable (or Contract Receivable) $2,857,143
– Cr Revenue $2,857,143
3. To recognize cost of sales for the period:
– Dr Cost of Goods Sold $2,000,000
– Cr Construction in Progress $2,000,000
4. To bill customer (if billed for some amount):
– Dr Accounts Receivable $BilledAmount
– Cr Progress Billings (contra‑asset or liability) $BilledAmount
Real‑world applications
– Construction companies (buildings, bridges, roads, energy facilities).
– Engineering and industrial contractors (large, multi‑year projects).
– Defense contractors for long lead‑time platforms (ships, aircraft) where costs and progress can be estimated.
– Certain custom software development projects (significant, client‑specific, multi‑period work).
– Large manufacturers with long delivery schedules sometimes use a form of POC.
Risks, ethical considerations, and controls
– Judgment intensity: POC relies on estimates of costs and percent complete; management bias or pressure can lead to premature or inflated revenue recognition.
– Earnings management risk: smoothing or accelerating revenue via optimistic cost estimates or reclassifying costs can distort reported performance. Historical scandals (e.g., Toshiba’s infrastructure unit understating costs) show consequences: restatements, leadership changes, regulatory scrutiny.
– Key controls to mitigate risk:
– Segregation of duties and written policies for estimating costs and recognizing revenue.
– Independent, periodic review of estimates (internal audit or external experts).
– Detailed documentation: timesheets, vendor invoices, change order approvals, progress reports, site inspections.
– Conservative reserve setting and prompt recognition of anticipated losses.
– Transparent disclosures to users of financial statements and proactive communication with auditors.
– Board/compensation structures that minimize perverse incentives to manipulate timing.
Tax and regulatory notes
– Tax treatment varies by jurisdiction. In some jurisdictions (including cases under U.S. tax law), long‑term contractors may be required or permitted to use the percentage‑of‑completion method for tax reporting; exceptions exist for small contractors or certain types of contracts. Check local tax rules and consult tax counsel.
– Under U.S. GAAP and IFRS, revenue‑recognition rules require measurement of performance and appropriate disclosure—follow ASC 606 (U.S. GAAP) or IFRS 15 guidance on recognizing revenue over time when performance obligations are satisfied over time.
Disclosure best practices for transparency
– State the method used to measure progress (cost‑to‑cost, efforts expended, output).
– Reconcile beginning and ending contract asset/liability balances (CIP vs. progress billings).
– Disclose significant judgments, changes in estimates, and any material losses recognized during the period.
– Explain major contracts and their expected completion dates when material to the business.
The bottom line
The percentage of completion method provides timely and economically meaningful recognition of revenue and profits for long‑term contracts, reflecting performance as work progresses. It improves comparability and reporting relevance versus the completed‑contract method but depends on reliable estimates and strong controls. Companies should adopt robust estimation processes, transparent disclosures, and independent oversight to minimize the risk of error or manipulation.
Sources
– Investopedia: “Percentage of Completion Method” (Tara Anand). https://www.investopedia.com/terms/p/percentage-of-completion-method.asp
– Public company disclosures (example): Fluor Corporation Form 10‑K, Note on major accounting policies (re: percentage of completion policies).
– Public reporting on accounting scandals (e.g., Toshiba infrastructure unit cost understatement, 2008–2014).
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.