By Danny Wong

There are many types of revenue recognition that are allowed under the Generally Accepted Accounting Principles (GAAP), and they all have different benefits and limitations depending on how you do business. The percentage-of-completion method (PoC) is a common revenue recognition method for companies that deal in long-term contracts.

Some companies need to have a way to recognize a portion of the revenue earned from a long-term contract before the project has been completed. In such cases, they generally employ the percentage-of-completion method of accounting, which is a way to determine what percentage of the revenue of the entire contract should be accrued during a specific time period.

Construction companies are some of the most frequent practitioners of the PoC method. For many of them, the bulk of their revenue comes from longer projects that can take months (or even years) to finish. These companies have to rely on percentage-of-completion methods in order for their financial statements to accurately reflect their revenues and expenditures during periods when these projects are ongoing.

Though it may seem obvious that construction companies would benefit from using PoC, construction is far from the only industry in which this method is useful. It can be applicable to a wide variety of situations, including for software companies that create custom products for clients that require ongoing development and frequent modifications.

As mentioned, there are many revenue recognition methods that a company can choose to employ. One of the most common is the sales-based method, where the entirety of the revenue is recognized as soon as the sale is complete. For a retail company, this would be the moment a customer decides to make a purchase, since all the work on the product has already been completed. For a hospitality company, revenue isn’t recognized until the guest stays at the property, even if a reservation and a deposit had been made months in advance.

Another common alternative to the percentage-of-completion method is the completed-contract method. Once the parameters of the contract have been fulfilled, then all of the revenue associated with that job is recorded at one time. Some organizations prefer to use the completed-contract method because of its simplicity; there is no need to calculate how much work was done during a specific time frame or, as a result, how much revenue should be attributed to it.

If other revenue recognition methods, such as the sales-based and completed-contract methods, offer relative simplicity in terms of recording income, then why would someone prefer to use PoC? Although it may be slightly more complicated, there are several advantages to using PoC for certain companies.

The first reason is that it tends to be a more accurate representation of the revenue earned. If the project is forecast to span multiple accounting periods, then recording the entirety of the revenue in a period long after most of the work was done can paint a less precise picture of the company’s financial health than if the PoC method were used.

Another important consideration is the expenses that are associated with the project. PoC doesn’t only cover when the revenue for a sale is recognized; it also dictates that the expenses are reported in the same way. The percentage of expenses incurred during the time period at hand is recorded along with the revenue, as opposed to the completed-contract method, which defers all the associated expenses along with the revenue. PoC allows you to see your project expenses as they occur.

Also, using PoC can help you more accurately assess your quarterly tax liability. While other options (such as the completed-contract method) allow you to defer all of your tax liability for the associated revenue until the project is complete, you’ll have to deal with it all at once. PoC allows you to more evenly distribute your total taxes due.

The most important factor involved in percentage-of-completion accounting is the firm’s ability to accurately estimate revenues and costs that will be recorded. That’s because the calculations rely on an estimation of the total costs that will be incurred over the life of the contract.

To determine how much revenue to record during a time period, you begin by dividing the expenses you have incurred from the beginning of the period until now by the total estimated expenses for the contract. This gives you the percentage of the work that has been completed during the period. Once you have calculated the percentage of work completed in the period, you then divide that by the total value of the contract to arrive at the amount of revenue you should recognize.

Here is a percentage-of-completion method example:

  • Your company is in the midst of a contract valued at $100 million that will last two years

  • During the first year, you incurred $15 million in expenses

  • You estimate an additional cost of $35 million in expenses during the second year, bringing the total expenses for the project to $50 million

  • At the end of the first year, you have therefore completed an estimated 30% of the work

  • Dividing that by the total contract value indicates that you should recognize $30 million in revenue for that period (30% of $100 million)

While the PoC revenue recognition method can be extremely beneficial for many organizations, it’s not without its limitations. As mentioned, in order for the method to be successful, the company must be able to estimate revenues, costs, and the total length of time of the project. If your business model is prone to wild fluctuations in materials costs, or your projects frequently run well beyond estimations, it may be better to stick with a more definitive revenue recognition method.

Additionally, in order for your revenue estimates with PoC to be accurate, you must be reasonably assured that you will collect on your receivables according to the timeline laid out in the contract. If you spend months or years recognizing incremental revenue and then have to move all of it into bad debt long after the project is completed, it could end up complicating your accounting.

Finally, it’s important to note that the PoC method leaves the door open for malfeasance by unethical actors. Of course, every accounting method has its vulnerabilities, and employees or companies can often find a way to exploit any system. However, PoC can be especially vulnerable to so-called “creative accounting” because it is inherently based on estimations spread across multiple time periods.

The first step to employing the percentage-of-completion method in your company is to create an honest assessment of its potential value to you. Ask yourself questions such as:

  • Do I earn a significant amount of revenue from contracts that span multiple accounting periods?

  • Will I be able to accurately estimate the parameters of each long-term project?

  • Is it more advantageous for my tax situation if I defer all expenses and revenue until the end of a contract or record a portion of them more frequently?

  • Are disputed contracts a rarity, or do they happen somewhat frequently?

Once you’ve determined that PoC is a good fit for your organization, then you need to have a plan for implementation. Make sure your methods of calculating revenue and expenses are standardized across all projects. Decide which methods you will use to verify the expenditures incurred during the various periods for which you will be recognizing revenue and expenses. Set your accounts receivable team up for success so they can invoice quickly and accurately, and collect promptly upon completion.

The percentage-of-completion accounting method will help your company better align its recorded revenues with its incurred expenses. A thorough understanding of its advantages and implications will help make you a better employee, manager, or company leader.
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