Definition
The Percentage of Completion Method is an accounting technique that records and recognizes income proportionally with the degree of completion of a project or contract, instead of just at the completion. In other words, as an activity progresses towards completion, a proportionate amount of revenue associated with that activity is recognized. This method provides a continuous and consistent measure of financial progress in long-term projects.
Key Takeaways
- The Percentage of Completion Method is a system used in accounting for long-term contracts, recognizing portions of revenues and expenses in proportion to the degree of completion of the project’s work.
- This method provides a more accurate representation of the company’s financial health during the period of the ongoing project. It allows for the recognition of anticipated losses immediately, instead of waiting until project completion.
- However, the Percentage of Completion Method might be complex to implement as it requires reliable estimates of total project revenues, costs, and degree of completion. Inaccurate estimation could lead to significant discrepancies in financial statements.
Importance
The Percentage of Completion Method is a significant concept in finance as it is used to recognize revenue and costs associated with long-term projects proportionate to the amount of work completed.
This method is crucial because it often provides a more accurate representation of a company’s financial health, especially for businesses engaged in large, long-term contracts such as construction and engineering.
By recognizing revenue gradually rather than at the project’s conclusion, the company can align revenue with related costs more precisely in each accounting period, providing a more balanced and realistic picture of the company’s profit margins and overall performance.
It also helps to smooth out earnings over time, reducing the risk of financial discrepancies or unexpected results at the end of the project.
Explanation
The Purpose of the Percentage of Completion Method in finance is primarily to account for long-term projects. It is used in situations where it is highly probable for the projects to span across multiple accounting periods.
Under this method, the revenue associated with a project is recognized progressively, in proportion to the amount of work completed. This helps to appropriately reflect the financial progress and status of ongoing projects in the company’s financial statements over several accounting periods.
The Percentage of Completion Method is most frequently used in the construction industry or for tailor-made goods or services. Its main advantage is that it allows businesses to reflect their financial reality more accurately over time, instead of having large spikes of revenue or costs at the end of long-term projects.
This makes financial results more consistent and predictable over time, providing more reliable information for decision-making to managers and investors.
Examples of Percentage of Completion Method
Construction Projects: One of the most common real world applications of the Percentage of Completion Method is in large scale construction projects. For example, a building construction company that is contracted to build a high-rise condominium would recognize revenue based on the percentage of the project completed in each accounting period. If it completed 25% of the project within the first year, it would recognize 25% of the total contract revenue that year.
Custom Manufactured Goods: A custom yacht builder may use the Percentage of Completion Method to recognize revenue. If it takes three years to complete a custom yacht, with steady progress made over the three years, the company would recognize a third of the revenue each year.
Software Development: A software development company that is contracted to deliver a complex software system over a two-year period may also use this method. If the development is expected to occur evenly over the two years, the company would recognize 50% of the revenue in the first year and 50% in the second year based on the progress of the project.
FAQs About Percentage of Completion Method
What is the Percentage of Completion Method?
The Percentage of Completion Method is an accounting technique in which the revenues, costs, and gross profit for a particular period are recognized based on the progress of a project.
When is the Percentage of Completion Method usually applied?
This method is often applied for long-term contracts, especially in industries like real estate and construction, where projects span over multiple accounting periods.
How is the Percentage of Completion calculated?
The percentage of completion is generally calculated by dividing the costs incurred to date by the total estimated costs of the contract.
What are the benefits of using the Percentage of Completion Method?
Using the Percentage of Completion Method enables a company to recognize revenue even if not all of the cash has been received, which can be beneficial for long-term projects. It provides a more accurate depiction of a company’s financial health during the period.
Are there any drawbacks to the Percentage of Completion Method?
While it provides a clearer snapshot of ongoing projects, it might be less reliable due to the use of estimated costs. Changes in these estimates can heavily impact the financial statements.
Related Entrepreneurship Terms
- Progress Billing
- Cost-to-cost Basis
- Estimated Total Revenue
- Unearned Revenue
- Long-term Contracts
Sources for More Information
- Investopedia: A comprehensive website that specializes in finance and investing education based on data and sound research.
- Accounting Tools: A resource offering courses, books, and practical guides on a wide range of accounting and finance topics.
- The Balance Small Business: An extensive information hub offering expert advice on starting, running, and growing a business.
- Corporate Finance Institute: A professional development and training organization focused on investment banking, private equity, corporate development, treasury, and corporate finance.
