What is the Percentage of Completion Method?
The percentage of completion method is an accounting method for recognizing not only revenue but also expenses for long-term projects which span over more than one accounting year. In this method, revenue is recognized on a yearly basis as a percentage of work completed during that year.
Revenue for a given year is calculated as follows:
Revenue to be recognized = (Percentage of Work Completed in the given period) * (Total Contract Value)
Here, the biggest challenge is to calculate the percentage of work completed.
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For eg:
Source: Percentage of Completion Method (wallstreetmojo.com)
How to Calculate the Percentage of Work Completed?
To estimate the progress of work or the completion percentage, companies can use either of the three methods:
#1 – Cost Method
In case of huge projects, the total cost which will be incurred on the project is estimated at the start of the project itself so that the company can accordingly quote a fee for the same. This cost can be taken as the basis for calculating the percentage of completion method as it is assumed that the revenue will go hand-in-hand with the cost incurred.
To determine the percentage of work completed, you can use the following formula:
Percentage of work completed = (Total Expenses incurred on the project till the close of the accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more) ÷ (Total Estimated Cost of the Contract)
The above formula gives the cumulative percentage of work completed until the close of the accounting period. From this, you need to subtract the percentage of work completed up to the last accounting period to arrive at the percentage of work completed in the current accounting year.
Example 1:
A company named Roads & Bridges has won a contract for the construction of a foot overbridge near a crowded railway station. It has estimated that the total cost for this project will be $ 10,00,000. The policy of the company is to add a margin of 20% on its cost estimateCost EstimateCost estimate is the preliminary stage for any project, operation, or program in which a reasonable calculation of all project costs is performed and thus requires precise judgement, experience, and accuracy.read more. So the finalized quotation for this project, which is agreed by both the parties, is $ 12,00,000. It is estimated the company will be able to finish the project in 3 years.
The company has incurred the following costs during the life of the project:
- Year 1: $ 1,00,000
- Year 2: $ 3,50,000
- Year 3: $ 4,75,000
- Year 4: $ 1,00,000
On the basis of the cost methodBasis Of The Cost MethodThe cost method is a method of accounting for investments in which the investment remains at its original cost on the balance sheet. Many financial instruments, such as investments and inventory/fixed assets, are accounted for using this method.read more of percentage completion, revenue can be recognised as follows:
| Year | Cost | Cumulative cost incurred | Cumulative % of completion | Year on year % | Cumulative revenue to be recognized | Year on year revenue |
| 1 | $ 1,00,000 | $ 1,00,000 | 10.00% | 10.00% | $ 1,20,000 | $ 1,20,000 |
| 2 | $ 3,50,000 | $ 4,50,000 | 45.00% | 35.00% | $ 4,20,000 | $ 3,20,000 |
| 3 | $ 4,75,000 | $ 9,25,000 | 92.50% | 57.50% | $ 6,90,000 | $ 2,70,000 |
| 4 | $ 1,00,000 | $ 10,25,000 | 102.50% | 102.50% | $ 12,30,000 | $ 5,40,000 |
| Total | $ 10,25,000 | $ 12,30,000 |
If you must have noticed, the revenue recognized is exceeding the total project contract value, which was finalized. This is because Roads & Bridges has exceeded the cost by $ 25,000 and revenue is exceed by exactly $ 25,000 + 20% = $ 30,000
However, revenue cannot be exceeded more than the contract value as the contractee will not pay any more than $ 12,00,000.
So the key take away from the above is that in the last year of the contract, revenue should be recognised only to the extent of the total contract value and the cumulative completion percentage cannot exceed 100%. Following will be the revised working for the above:
| Year | Cost | Cumulative cost incurred | Cumulative % of completion | Year on year % | Cumulative revenue to be recognized | Year on year revenue |
|---|---|---|---|---|---|---|
| 1 | $ 1,00,000 | $ 1,00,000 | 10.00% | 10.00% | $ 1,20,000 | $ 1,20,000 |
| 2 | $ 3,50,000 | $ 4,50,000 | 45.00% | 35.00% | $ 4,20,000 | $ 3,20,000 |
| 3 | $ 4,75,000 | $ 9,25,000 | 92.50% | 57.50% | $ 6,90,000 | $ 2,70,000 |
| 4 | $ 1,00,000 | $ 10,25,000 | 100.00% | 100.00% | $ 12,00,000 | $ 5,10,000 |
| Total | $ 10,25,000 | $ 12,00,000 |
#2 – Efforts Expended Method
This method is similar to the cost method; however, instead of using the cost, companies can use the efforts involved in completing the project. The efforts mentioned in this method imply any of the following:
- Direct man-hours that are required to complete the project – This should be used when the project is labor dominated, the major cost is also of labor, and the project can be broken down into several man-hours.
- Machine hours that are required to complete the project – As opposed to the above, machine hours should be used as the basis for the percentage of completion method when the project is automated in nature and requires machinery for the completion of the project. In this case, the major cost will be attributable to the machinery.
- Material consumed can also be one of the key requirements for the project. In this case, the quantity of material consumed will be taken as the basis.
Example 2
ABC Company has won a contract for excavation of an area which will take 2 years to complete. The excavation has to be done manually as it is an archaeological site on account of which labor costLabor CostCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more will be the key cost for completion of the project.
The company has estimated that it will require 50,000 man-hours to complete the work. It has also decided to opt to calculate the percentage of completion by using the efforts expended method.
Total estimated cost for the project = $ 5,00,000
| Year | Man Hours | Cumulative man hours | Cumulative % of completion | Year on year % | Cumulative revenue to be recognized | Year on year revenue |
|---|---|---|---|---|---|---|
| 1 | 17,000 | 17,000 | 34.00% | 34.00% | $ 1,70,000 | $ 1,70,000 |
| 2 | 13,000 | 30,000 | 60.00% | 26.00% | $ 3,00,000 | $ 1,30,000 |
| 3 | 18,000 | 48,000 | 96.00% | 36.00% | $ 4,80,000 | $ 1,80,000 |
| Total | 48,000 | $ 4,80,000 |
In the above case, the actual man-hours are lesser than the estimated man-hours. As per the percentage of completion method, the company has to recognize only $ 4,80,000. However, as per contract, the company will receive $ 5,00,000. So during the last year of the project, the company can recognize the balancing revenue, and the cumulative % of completion should be 100% instead of 96%.
Revised revenue recognition will be as follows:
| Year | Man Hours | Cumulative man hours | Cumulative % of completion | Year on year % | Cumulative revenue to be recognized | Year on year revenue |
|---|---|---|---|---|---|---|
| 1 | 17,000 | 17,000 | 34.00% | 34.00% | $ 1,70,000 | $ 1,70,000 |
| 2 | 13,000 | 30,000 | 60.00% | 26.00% | $ 3,00,000 | $ 1,30,000 |
| 3 | 18,000 | 48,000 | 100.00% | 40.00% | $ 5,00,000 | $ 2,00,000 |
| Total | 48,000 | $ 5,00,000 |
#3 – The Units-of-Delivery Method
Many times, a long-term contract can be split into multiple smaller units that are delivered to the customer, and the price, delivery schedule, units, etc. of each separate unit are mentioned in the contract itself.
Example 3
The following is the extract of deliverables of a contract where the contractor is involved in certain activities of construction of business:
| Sr. No. | Particulars | Timelines for completion | Amount per unit | No. of units | Total Amount |
|---|---|---|---|---|---|
| A.1 | Air purification system | 01-Feb-18 | $ 1,00,000 | 5 | $ 5,00,000 |
| A.2 | Elevators | 01-Mar-18 | $ 2,22,000 | 10 | $ 20,22,000 |
| A.3 | Drainage system | 15-Apr-18 | $ 3,00,000 | 15 | $ 45,00,000 |
| A.4 | Fire Protection system | 31-May-18 | $ 1,60,750 | 2 | $ 3,21,500 |
| A.5 | Emergency alarm system | 31-Jul-18 | $ 11,00,367 | 2 | $ 22,00,734 |
| A.6 | Other miscellaneous equipment | 31-Aug-18 | $ 53,00,000 | 1 | $ 53,00,000 |
| A.8 | Generators & Transformers | 31-Dec-18 | $ 2,65,700 | 7 | $ 18,59,900 |
| A.9 | Telecommunication system | 15-Jan-18 | $ 8,18,550 | 8 | $ 65,48,400 |
| A.10 | Treated water system | 01-May-18 | $ 5,90,000 | 12 | $ 70,80,000 |
| Total | $ 305,30,534 |
From the above, the following is the actual delivery in the financial year Jan 2017 to Dec 2017:
| Sr. No. | Particulars | Amount per unit | Delivered units | Total Amount |
|---|---|---|---|---|
| A.1 | Air purification system | $ 1,00,000 | 2 | $ 2,00,000 |
| A.2 | Elevators | $ 2,22,000 | 3 | $ 6,66,000 |
| A.3 | Drainage system | $ 3,00,000 | 3 | $ 9,00,000 |
| A.4 | Fire Protection system | $ 1,60,750 | 1 | $ 1,60,750 |
| A.5 | Emergency alarm system | $ 11,00,367 | – | – |
| A.6 | Other miscellaneous equipment | $ 53,00,000 | – | – |
| A.8 | Generators & Transformers | $ 2,65,700 | 4 | $ 10,62,800 |
| A.9 | Telecommunication system | $ 8,18,550 | 2 | $ 16,37,100 |
| A.10 | Treated water system | $ 5,90,000 | – | $ 2,00,000 |
| Total | $ 46,26,650 |
As per the units-of-delivery method of Percentage Completion, the company can recognize $ 46,26,650 as revenue in the given financial year.
Pre-requisites for the Percentage of Completion Method
One of the basic conservatism principles of accounting is to Prudence. This accounting principle requires that a certain degree of caution should be exercised while recording revenue in the books of accounts.
Keeping this principle in mind, the use of a percentage of completion method should be used for booking revenue in the books of accounts only when the following can be assured about the contract:
- Collections with regards to the contract are assured. To ensure this, companies ask for bank guarantees, performance guarantees from the debtor. They can also check the creditworthiness of the company before entering into a contract with them.
- The company can fairly determine the progress of work done on the contract. It is important because the revenue is directly related to progress. If the progress itself is incorrect, the revenue presented in the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more will be incorrect. There are chances of fraudulent activities if this part is not properly reviewed by the top management.
- Both parties to the contract should be in a state to fulfill the contractual obligations. The contractor (company recognizing the revenue) should be in a state to complete the project. The contractee (a company who wants the work to be done) should be not only able to pay but also be able to take the complete responsibility of the project once the work is completed and the risk is transferred to them.
Journal Entries for Percentage Completion Method
The revenue recognized under this is not billed to the customer. Revenue recognition, in this case, should be routed to a different account – “Unbilled contract receivables.”
Example 1 (Continued):
Company Roads and Bridges will pass the following journal entries in its books of accounts for revenue recognized under the percentage of completion method:
Year 1
| To Unbilled Contract Receivables A/c | $ 1,20,000 |
| By Contract Revenue Earned A/c | $ 1,20,000 |
Year 2
| To Unbilled Contract Receivables A/c | $ 3,20,000 |
| By Contract Revenue Earned A/c | $ 3,30,000 |
Year 3
| To Unbilled Contract Receivables A/c | $ 2,70,000 |
| By Contract Revenue Earned A/c | $ 2,70,000 |
Year 4
| To Unbilled Contract Receivables A/c | $ 5,10,000 |
| By Contract Revenue Earned A/c | $ 5,10,000 |
| To Accounts Receivable A/cAccounts Receivable A/cAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more | $ 12,00,000 |
| By Unbilled Contract Receivables A/c | $ 12,00,000 |
At the end of the contract, the company will raise an invoice and can then transfer the Unbilled Contract Receivable A/c to Accounts Receivable A/c. Till then, Unbilled Contract Receivable A/c will be shown as a shown as an asset in the balance sheet.
If an advance is received towards the contract, the following entry can be passed in the books:
| Bank A/c | $ 2,00,000 |
| Advance received A/c | $ 2,00,000 |
It can be reduced from the Unbilled Contract Receivable A/c while preparing the balance sheet.
Conclusion
Percentage of completion method is used by the business entities whose business accepts long term projects where they book the revenue and expenses related to that particular project in more than one accounting year, taking the percentage of the project completed as the criterion or base for recognition of revenue and booking of expenses.
Percentage of Completion Method Video
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