The percentage of completion method is a fundamental accounting approach in the construction industry, used to recognize revenue and expenses in relation to the completed portion of a project. This guide explores the criteria, benefits, and challenges of this method and how Certified Public Accountants (CPAs) can assist in its effective implementation.
Introduction
In construction accounting, accurately recognizing revenue and expenses is crucial due to the long-term nature of projects. Therefore, it’s essential to match revenues with corresponding costs. Furthermore, precise accounting ensures financial stability and project viability over time. The percentage of completion method addresses this need by allowing companies to report part of the income and expenses based on the project’s progress. This approach provides a more accurate financial picture of ongoing projects, aiding in better financial management and decision-making.
The Percentage of Completion Method Explained
1. Definition and Criteria
- What It Is:
- The percentage of completion method recognizes revenues and expenses based on the progress towards completion of a construction project. This progress is measured by the ratio of costs incurred to the total estimated costs of the project.
- Key Criteria for Using This Method:
- Measurable Progress: There must be a clear, reliable method to measure the progress of the project.
- Reasonable Estimation of Costs: Total estimated costs can be reasonably determined.
- Collectibility of Revenue: The ability to collect payment is reasonably assured.
2. Calculating Percentage of Completion
- Formula:
- The percentage of completion is calculated as:
- Percentage of Completion=Total Costs Incurred to DateTotal Estimated Costs
- Percentage of Completion=
- Total Estimated Costs
- Total Costs Incurred to Date
- This ratio is then used to determine the amount of revenue and profit to be recognized.
- Example:
- If a construction project has total estimated costs of $1,000,000 and $250,000 has been incurred in costs so far, the percentage of completion is 25%. If the total contract value is $1,200,000, then the revenue to be recognized would be 25% of $1,200,000 = $300,000.
3. Revenue Recognition
- How It Works:
- To recognize revenue for the period, multiply the total contract value by the calculated percentage of completion.
- Expenses are recognized in the same proportion, ensuring that profits are matched to the extent of work completed.
4. Benefits of This Method
- Improved Financial Accuracy:
- Provides a realistic view of profitability and progress, as revenue recognition is aligned with work completion.
- Enhanced Decision Making:
- Timely and accurate financial information helps management make better-informed decisions regarding project execution and resource allocation.
- Cash Flow Management:
- By recognizing revenue earlier, this method can improve cash flow predictions and management.
5. Challenges and Considerations
- Estimation Risks:
- Requires accurate estimation of total project costs, which can be difficult and subject to changes.
- Complexity:
- More complex to implement and maintain than other methods, requiring detailed tracking of costs and progress.
- Regulatory Compliance:
- Must be applied consistently and in accordance with applicable accounting standards and regulations.
How CPAs Can Help Implement the Percentage of Completion Method
1. Setting Up the Accounting System
- Expertise:
- CPAs design and set up accounting systems to facilitate the percentage of completion method, ensuring accurate data capture and processing.
2. Training and Support
- Knowledge Sharing:
- CPAs train company staff on how to implement and maintain the percentage of completion method, including how to track and report costs and revenues effectively.
3. Ongoing Monitoring and Adjustments
- Adjustment Assistance:
- CPAs assist in reviewing and adjusting estimates of project costs as new information becomes available, helping maintain the accuracy of revenue recognition.
4. Financial Analysis and Reporting
- Reporting:
- They prepare financial reports that reflect the true financial status of projects under the percentage of completion method.
- Analysis:
- CPAs analyze completed projects to assess the accuracy of cost estimates and improve future project forecasting and bidding.
5. Compliance and Audit Support
- Regulatory Guidance:
- CPAs ensure that revenue recognition under this method complies with accounting standards such as GAAP or IFRS.
- Audit Preparation:
- They help prepare for audits by documenting the processes used and providing evidence of progress and cost tracking.
Conclusion
The percentage of completion method is an essential tool in construction accounting, providing a clear and accurate financial picture of ongoing projects. While it offers significant benefits in terms of financial management and decision-making, it also presents challenges that require careful management. CPAs play a vital role in implementing this method effectively, from setting up the necessary systems and providing training to ensuring compliance and assisting with financial reporting. With the right approach and expert guidance, construction companies can leverage this method to enhance their financial stability and project management success.
