Percentage of completion method: Meaning, Criticisms & Real-World Uses

What Is the Percentage of Completion Method?

The percentage of completion method is an accounting principles used primarily by businesses that engage in long-term contracts, such as construction or defense projects. It allows a company to recognize revenue recognition and associated expenses over the life of a project, in proportion to the work completed, rather than waiting until the entire project is finished. This approach provides a more accurate representation of a company's financial performance throughout a multi-period contract, aligning revenue with the efforts expended to earn it. The percentage of completion method is a key component of accrual accounting, aiming to match revenues with the costs incurred to generate them.

History and Origin

The percentage of completion method has a long history in accounting for significant, multi-year projects. Before modern accounting standards, companies often faced a dilemma: how to accurately report financial progress on contracts spanning several fiscal periods. Early accounting practices might have waited until a project's full completion, leading to volatile financial reporting, where large amounts of revenue and profit would suddenly appear in one period.

To address this, the percentage of completion method emerged as a way to smooth out reported income. In the United States, its formal recognition under Generally Accepted Accounting Principles (GAAP) evolved over time. The Financial Accounting Standards Board (FASB) played a significant role in standardizing its application. For instance, FASB Statement No. 56, issued in February 1982, designated specific accounting and reporting principles for construction contractors, including the percentage of completion method, as preferable for certain accounting changes.⁶ More recently, the accounting landscape has been significantly reshaped by ASC 606, the new revenue recognition standard. While ASC 606 does not explicitly use the term "percentage of completion," it maintains the principle of recognizing revenue over time for long-term contracts where control of the asset or service transfers continuously to the customer, often employing similar input or output methods to measure progress.⁵,⁴

Key Takeaways

The percentage of completion method recognizes revenue and expenses on long-term contracts proportionally to the work completed, rather than upon final delivery.
It provides a smoother, more consistent depiction of a company's financial performance over the life of a project.
This method is primarily used for contracts where reliable estimates of costs and progress can be made.
It contrasts with the completed contract method, which defers all revenue and expense recognition until project completion.
Modern revenue recognition standards (like ASC 606) often incorporate principles similar to the percentage of completion method for contracts satisfied over time.

Formula and Calculation

The core idea behind the percentage of completion method is to determine the proportion of the project completed at a given point in time. This percentage is then applied to the total contract revenue and total estimated contract costs to calculate the revenue and gross profit to be recognized in the current period.

A common approach for calculating the percentage of completion is the cost-to-cost method:

\text{Percentage of Completion} = \frac{\text{Total Costs Incurred to Date}}{\text{Total Estimated Costs of Contract}}

Once the percentage of completion is determined, the revenue and gross profit for the period are calculated as follows:

\text{Revenue to Be Recognized} = \text{Total Contract Price} \times \text{Percentage of Completion} - \text{Revenue Recognized in Prior Periods}

\text{Gross Profit to Be Recognized} = \text{Total Estimated Gross Profit} \times \text{Percentage of Completion} - \text{Gross Profit Recognized in Prior Periods}

Here:

Total Costs Incurred to Date: The cumulative cost of goods sold incurred on the project up to the reporting date.
Total Estimated Costs of Contract: The total projected costs to complete the entire contract.
Total Contract Price: The full agreed-upon amount the customer will pay for the project.
Revenue Recognized in Prior Periods: The accumulated revenue recognized in previous accounting periods for the same contract.
Total Estimated Gross Profit: The total expected profit from the contract, calculated as Total Contract Price - Total Estimated Costs of Contract.
Gross Profit Recognized in Prior Periods: The accumulated gross profit recognized in previous periods.

Interpreting the Percentage of Completion Method

Interpreting the percentage of completion method involves understanding that the reported revenue and income are based on estimates, not final outcomes. As a project progresses, the percentage of completion method allows companies to reflect a portion of the project's profitability on their financial statements each period. This provides stakeholders with insights into the ongoing performance of significant undertakings, even before they are fully finished.

For users of financial statements, it means that the revenue recognized is a function of progress. A higher percentage of completion implies more work has been done and more revenue can be recognized. However, it is crucial to consider the reliability of the cost estimates, as inaccuracies can lead to misstated revenue or net income. Analysts often scrutinize changes in estimated costs and their impact on future recognized revenue. The method emphasizes the transfer of control of goods or services to the customer over time, tying revenue recognition directly to the satisfaction of performance obligations.

Hypothetical Example

Consider "BuildWell Construction," which enters into a contract to build a specialized factory for a total price of $10 million. The estimated total cost for the project is $8 million. The contract spans three years.

Year 1:

Costs incurred in Year 1: $2 million
Percentage of Completion = $2,000,000 / $8,000,000 = 25%
Revenue to be recognized in Year 1 = $10,000,000 * 25% = $2,500,000
Gross Profit to be recognized in Year 1 = ($10,000,000 - $8,000,000) * 25% = $2,000,000 * 25% = $500,000

Year 2:

Costs incurred in Year 2: $3 million (Cumulative costs to date: $2M + $3M = $5M)
Percentage of Completion = $5,000,000 / $8,000,000 = 62.5%
Revenue to be recognized in Year 2 = ($10,000,000 * 62.5%) - $2,500,000 (from Year 1) = $6,250,000 - $2,500,000 = $3,750,000
Gross Profit to be recognized in Year 2 = ($2,000,000 * 62.5%) - $500,000 (from Year 1) = $1,250,000 - $500,000 = $750,000

Year 3:

Costs incurred in Year 3: $3 million (Cumulative costs to date: $5M + $3M = $8M)
Percentage of Completion = $8,000,000 / $8,000,000 = 100%
Revenue to be recognized in Year 3 = ($10,000,000 * 100%) - ($2,500,000 + $3,750,000) = $10,000,000 - $6,250,000 = $3,750,000
Gross Profit to be recognized in Year 3 = ($2,000,000 * 100%) - ($500,000 + $750,000) = $2,000,000 - $1,250,000 = $750,000

This example illustrates how the percentage of completion method allocates the total revenue and profit over the project's duration, matching them with the progress made. The company would also track contract assets on its balance sheet, representing costs incurred and profit recognized in excess of billings.

Practical Applications

The percentage of completion method is widely applied in industries characterized by large-scale, long-duration projects. Its primary use cases include:

Construction: Building commercial properties, infrastructure projects (bridges, roads), and residential developments often involves multi-year timelines, making the percentage of completion method essential for reflecting ongoing financial progress.
Aerospace and Defense: Companies manufacturing aircraft, spacecraft, or complex defense systems for government contracts typically use this method to account for the substantial and lengthy production cycles.
Software Development (Custom Projects): For highly customized software development projects that span extended periods and involve significant integration, this method can be appropriate if revenue is recognized over time as the customer obtains control.
Professional Services (Large Engagements): Large consulting or engineering projects with clearly defined stages and measurable progress can also leverage the principles of this method to recognize revenue as services are rendered.

For tax purposes, the Internal Revenue Service (IRS) provides guidance on accounting periods and methods, including those for long-term contracts. IRS Publication 538 outlines these rules, indicating that specific methods, like the percentage of completion method, are mandated for certain types of long-term contracts, particularly in construction.³,² This ensures that taxable income is recognized consistently with the economic substance of the work performed.

Limitations and Criticisms

While the percentage of completion method offers a more timely reflection of a company's financial performance, it is not without its limitations and criticisms:

Reliance on Estimates: The primary drawback is its heavy reliance on accurate estimates of total contract costs and the degree of completion. If these estimates are inaccurate or change significantly, previously recognized revenue and profit may need to be adjusted, potentially leading to material restatements. Such adjustments can complicate the analysis of a company's historical financial performance and cash flow.
Potential for Manipulation: The subjective nature of cost estimation can create opportunities for management to influence reported earnings. Companies might accelerate or defer the recognition of revenue by altering cost estimates, impacting their reported net income for a given period. This makes thorough audit procedures crucial.
Uncertainty of Collectibility: Recognizing revenue before a project is fully complete means that cash may not yet have been received. If the customer's ability to pay declines or the project faces unforeseen issues leading to non-payment, the recognized revenue might ultimately be uncollectible.
Complexity: Applying the percentage of completion method, especially for complex contracts with multiple performance obligations and variable consideration, can be intricate and require significant accounting expertise.
Enforcement Actions: Regulatory bodies, such as the Securities and Exchange Commission (SEC), actively monitor companies for improper revenue recognition practices, including those that misuse the percentage of completion method. The SEC has brought enforcement actions against companies and executives for allegedly orchestrating schemes to overstate revenue by recognizing it prematurely or based on non-binding agreements.¹ This highlights the importance of robust internal controls and accurate application of accounting standards.

Percentage of Completion Method vs. Completed Contract Method

The percentage of completion method and the completed contract method are two distinct approaches for recognizing revenue on long-term contracts. The fundamental difference lies in the timing of revenue and expense recognition.

Feature	Percentage of Completion Method	Completed Contract Method
Revenue Recognition	Revenue and expenses are recognized gradually over the life of the contract as work progresses.	All revenue and expenses are recognized only upon the final completion and acceptance of the entire contract.
Financial Reporting	Provides a smoother, more consistent depiction of earnings and financial performance across reporting periods.	Can lead to volatile financial statements, with large amounts of revenue and profit (or loss) recognized in a single period.
Applicability	Preferred when reliable estimates of project costs and progress can be made.	Used when reliable estimates are difficult to determine, or for shorter-term, less complex long-term contracts (e.g., qualifying small contracts for tax purposes).
Balance Sheet Impact	Recognizes contract assets (costs and recognized profit in excess of billings) or contract liabilities (billings in excess of costs and recognized profit) on an ongoing basis.	Accumulates costs in an asset account until completion, then moves them to cost of goods sold upon recognition of revenue.

The choice between these methods, particularly under older accounting standards, significantly impacted a company's reported financial results. With the adoption of ASC 606 (the new revenue recognition standard) by both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), the emphasis has shifted to a principles-based approach focusing on when control of goods or services transfers to the customer and the satisfaction of performance obligations. While the term "percentage of completion" may not be explicitly used in ASC 606, the method's underlying principle of recognizing revenue over time continues to be relevant for contracts where control transfers continuously.

FAQs

What types of contracts typically use the percentage of completion method?

This method is primarily used for long-term contracts where performance extends over multiple accounting periods, such as construction projects, large-scale manufacturing (e.g., ships, aircraft), and custom software development. It applies when the company can reliably estimate progress toward completion and when the customer obtains control of the asset or service as the work is performed.

How does the percentage of completion method affect a company's financial statements?

It allows companies to recognize revenue and related expenses progressively, rather than all at once at the end of a project. This results in smoother, more predictable reported net income and gross profit over the life of the contract, providing a more accurate picture of a company's ongoing financial performance and profitability.

What are the risks associated with using the percentage of completion method?

The main risk stems from its reliance on estimates of total project costs and progress. If these estimates are inaccurate or change significantly during the project, the amount of recognized revenue and profit may be misstated, potentially leading to financial restatements. This method also requires careful judgment in determining the true transaction price and identifying distinct performance obligations.