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.
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.
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.