The important thing to remember is that contractors must be consistent in how they calculate the percent complete. Accounting for income and expenses can present a real challenge for contractors, especially on long-term projects. The percentage of completion method is one of the most common methods of accounting used in construction. In this article, we’ll explain the percentage of completion method, how it works, and give you some real-life examples.

Implementing the Percentage of Completion Method in Real-World Scenarios

Understanding these nuances is key to effectively managing percentage of completion accounting. Clear communication between project management and accounting teams is crucial to reconcile these differences and maintain a healthy cash flow. Automating your revenue recognition processes can help minimize these discrepancies. Schedule a demo with HubiFi to learn how we can help streamline your revenue recognition. Both GAAP and IFRS endorse the percentage of completion method for revenue recognition percentage of completion method on long-term contracts.

The Basics of Percentage of Completion Accounting in Construction

Project completion is calculated based on entered and approved project time entries. The project record shows the percentage of completion for the project in that period. The capital costs are debited to construction in progress and in most cases credited to accounts payable. The credit side of this entry might be to cash if paid for immediately or to the business’s inventory if it used the inventory assets in the construction. This could occur, for example, if a building supply company determines that its cheapest route for drywall is to use its supply that it would normally sell in its normal business operations.

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In such cases, revenue recognition must wait until acceptance, even if work is technically complete. In manufacturing and shipbuilding, progress is measured by units completed or shipped. A phased rollout, starting with high-value or low-risk projects, allows companies to refine their approach before full adoption.

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For a deeper dive into data-driven decisions, consider scheduling a free data consultation with HubiFi. The percentage of completion method offers a systematic approach to aligning financial reporting with the actual progress of work performed. This is especially critical for long-term contracts, where waiting until a project’s completion to recognize revenue could significantly distort a company’s financial performance over multiple periods. Recognizing revenue incrementally allows stakeholders to assess profitability and operational efficiency with greater accuracy.

By applying the cost-to-cost method, you can front-load revenue recognition, capturing the largest portion of project revenue in the job’s early stages. That journal entry is reversed on the first day of the next reporting period. The accountant makes a journal entry at the end of the month to adjust the excess costs, excess billings and current year percentage of completion revenue accounts. The amounts billed in the current period now reflect the actual current costs over the estimated total costs of the project.

• In both jobs, the contract amount has increased from the first month to the second.
• By recognizing revenue in alignment with actual project work, businesses avoid sudden profit spikes or drops that can distort their financial picture.
• Schedule a demo with HubiFi to learn how we can help streamline your revenue recognition.
• When implemented correctly, it transforms financial management from a reactive task into a proactive tool for strategic decision-making.
• For construction firms, effectively managing financial statements is an important building block for success.

The effect of this journal is to include an amount equal to the income recognized for the period as a debit to the construction in progress account. The balance on the construction in process account is now the revenue recognized of 1,625 (300 normal balance + 450 + 350 + 525) which again represents the cumulative costs plus income recognized to date. Without the PCM, the revenue recognized during the reporting period would simply equal the total you billed for the period. Ultimately, this would not accurately reflect the amount of work performed, and this would cause large, improper swings in profitability from period to period. The PCM corrects this by recording the overbillings(liability) and underbillings (asset) on the balance sheet.

• This approach is more conservative and is often used when project outcomes are uncertain or when it is difficult to measure progress reliably.
• Laura Chapman holds a Bachelor of Science in accounting and has worked in accounting, bookkeeping and taxation positions since 2012.
• The efforts-expended method provides a nuanced perspective that accounts for the intensity of labor or resources invested at each stage of the project.
• Each small job will be considered as finished only after they are delivered to the customers.
• While the percentage of completion method offers valuable insights into project profitability, it also presents potential risks.

Nick simplifies how to calculate and record revenue based on incurred costs, utilizing lively explanations to illustrate journal entries for construction revenue and expenses per accounting period. Gain a practical understanding of this method’s detailed mechanics and applications in managing construction project finances optimally. An analyst would learn that changes to total estimated contract costs or losses, if any, are recognized in the period in which they are determined by the company. While the cost-to-cost method is popular, other methods might be more suitable depending on your project. For instance, if your project involves producing a set number of identical units, the units-completed method can be a good fit.

Companies must provide transparent disclosures in financial statements regarding revenue recognition methods, assumptions, and changes in estimates. For example, if a software development project is expected to require 10,000 labor hours and 2,500 hours have been logged, then the project is 25 percent complete, and revenue can be recognized accordingly. Input-based methods focus on the resources consumed during the project to assess completion levels. The company has estimated that it will require 50,000 person-hours to complete the work. It has also decided to opt to calculate the percentage of completion by using the efforts expended method.

• The credit side of this entry might be to cash if paid for immediately or to the business’s inventory if it used the inventory assets in the construction.
• When you reach this point, the percentage of completion (POC) revenue recognition method can be extremely helpful.
• ERPs like SAP and NetSuite allow direct integration of project data with accounting functions.
• The price, delivery schedule, units, etc., of each separate unit, are mentioned in the contract.
• Percentage of completion is a method of accounting for long-term projects in which revenue and expenses are recognized based on the percentage of work they have completed during the period.
• For a deeper look into financial reporting best practices, check out the insights on the HubiFi blog.
• This method requires assured payment and a reliable estimation of completion stages.

In general, if GAAP allows for the combination of multiple contracts for revenue recognition purposes, then these contracts could also be combined for assessing and estimating the loss provision. Conversely, if the contracts are not combined or are segmented for revenue recognition, loss provisions would be recognized for each segment. This concept generally holds true in the upcoming ASC 606 Revenue Recognition guidance, with the clarification that contracts that are not combined are analyzed for provision at the contract level. During the construction, company needs to record revenue, expense and accounts receivable.