Percentage of Completion Method

The Percentage of Completion (POC) method is an accounting practice used primarily in the construction and engineering sectors, where projects can spread over multiple accounting periods. This method allows a company to recognize revenue and expenses related to long-term projects in proportion to the project’s completion, providing a more accurate representation of financial performance and reducing income statement volatility.

Key Concepts of the Percentage of Completion Method

Revenue Recognition

The POC method involves recognizing revenue and gross profit each accounting period based on the progress of the project. This is done by multiplying the total contract revenue by the percentage of completion. This provides a more consistent revenue stream over the life of the project compared to the completed-contract method, which recognizes revenue only when the project is finished.

Cost Measurement

The costs associated with the project are also recognized proportionally over the project’s duration. This typically includes direct costs like labor and materials, as well as allocated overhead costs. The method aligns costs with the revenue recognized, ensuring that both are reported based on the project’s progress.

Percentage of Completion Calculation

There are various ways to calculate the percentage of completion, including:

• Cost-to-cost method: This is the most common and calculates the percentage of completion by dividing the incurred costs to date by the estimated total costs. [ \text{Percentage of Completion} = \frac{\text{Costs Incurred to Date}}{\text{Total Estimated Cost}} ]

• Efforts-expended method: This calculates completion based on the proportion of efforts expended to date compared to the total estimated efforts required.

• Units-of-delivery method: This approach calculates completion based on the number of units delivered compared to the total units expected to be delivered.

Example Calculation

To illustrate, consider a construction company that has a $10 million contract to build a commercial building. If $6 million of costs have been incurred to date and the total estimated costs for the project are $9 million, the percentage of completion is:

[ \text{Percentage of Completion} = \frac{6,000,000}{9,000,000} = 66.67\% ]

Given this percentage, the revenue recognized to date would be:

[ \text{Revenue Recognized} = 66.67\% \times 10,000,000 = 6,667,000 ]

The gross profit recognized would be the revenue recognized less the incurred costs:

[ \text{Gross Profit Recognized} = 6,667,000 - 6,000,000 = 667,000 ]

Advantages of the Percentage of Completion Method

1. Accurate Financial Reporting: Aligns revenue and expenses with project completion, providing a more accurate financial picture.
2. Income Smoothing: Reduces income statement volatility by distributing revenue and expenses over the project’s life.
3. Early Revenue Recognition: Allows for earlier recognition of revenue, enhancing cash flow management.
4. Project Management Insight: Offers insights into project performance and profitability throughout its life cycle.

Disadvantages of the Percentage of Completion Method

1. Complexity: Requires detailed tracking of costs and progress which can be resource-intensive.
2. Estimation Risks: Relies on accurate initial cost and revenue estimates; incorrect estimates can lead to significant financial misstatements.
3. Regulatory Scrutiny: Subject to stringent accounting standards and audits, increasing administrative burden.

Regulatory Framework

The POC method is supported by various accounting standards, including:

• GAAP (Generally Accepted Accounting Principles): Specifically, ASC 606 which lays down guidelines for revenue recognition.
• IFRS (International Financial Reporting Standards): IFRS 15 guides on revenue from contracts with customers.

Companies follow these standards to ensure consistent and transparent financial reporting across industries and regions.

Industry Application

Construction

The construction industry extensively uses the POC method due to the typically long-duration projects. It allows companies to recognize revenue and costs progressively, providing a clearer financial picture over time.

Engineering

Engineering projects, often spanning several years, benefit from the POC method as it matches efforts and financial recognition, essential for managing long-term contracts.

Software Development

For large-scale software development projects, where deliverables are completed over extended periods, the POC method helps in recognizing revenues as and when parts of the project are completed.

Conclusion

The Percentage of Completion method is a valuable accounting approach for long-duration projects, offering advantages in revenue recognition, financial accuracy, and project management. However, its complexity and reliance on accurate estimates necessitate robust project tracking and financial management systems.

For detailed policies on the method, visit:

Financial Accounting Standards Board (FASB) International Financial Reporting Standards (IFRS) Foundation