Constructing an accurate picture of a construction project's financial progress can be incredibly challenging.
However, by utilizing the percentage-of-completion accounting method, companies can systematically allocate revenues and expenses over the course of long-term projects.
In this post, we'll define the percentage-of-completion method, walk through the formula, look at key journal entries, and discuss the major advantages and limitations of this approach.
Introduction to Construction Contract Accounting and the Percentage-of-Completion Method
Construction contract accounting involves applying specific accounting principles to long-term construction projects. The percentage-of-completion method is commonly used to allocate revenues and expenses across the timeline of these complex projects.
Defining construction contract accounting
Construction accounting covers the specialized methods for recognizing revenues and expenses over the life of large building projects, which often span multiple reporting periods. Key aspects include:
- Managing costs and billing across changing timeframes and budgets
- Tracking percentage of completion to recognize revenues
- Handling retainages and complex client contracts
- Identifying and mitigating risks from weather, materials, labor, etc.
Key challenges with construction accounting
Construction projects present unique accounting challenges, including:
- Long timeframes - Projects can take months or years, spanning multiple reporting periods. Costs and revenues must be properly accrued and allocated.
- Revenue recognition - Complex rules on percentage of completion impact when revenues can be recorded.
- Cost overruns - Unexpected costs from delays, weather, materials are common and can be substantial.
- Contract complexity - Retainages, change orders, claims can make revenue recognition difficult.
Introducing the percentage-of-completion method
To deal with these issues, the percentage-of-completion method systematically allocates revenues, expenses, and profit across the timeline and phases of construction projects based on:
- Costs incurred to date - The amount spent on the project so far determines the percent complete. More costs = higher completion percent.
- Accrual basis - Revenues and expenses are recognized as project activity occurs over time, not just when billing happens. This matches timing of revenue and expenses.
The percentage-of-completion method is an accrual-based approach that aims to properly recognize construction revenues and direct expenses as projects progress.
What is the percentage of completion method in construction accounting?
The percentage of completion (POC) method is an accounting technique used in the construction industry to recognize revenues and expenses over the course of a long-term project.
With the POC method, revenue and costs are recognized as work on the project progresses based on the percentage completed during each period. This allows builders to better match revenues with expenses incurred over the duration of a project rather than having to recognize all revenues when the project is finished.
The formula to calculate percentage of completion is:
Percentage of Completion = Costs Incurred to Date / Total Estimated Costs
Some key things to know about the POC method:
- Revenue recognized each period is calculated as Percentage of Completion x Total Contract Price
- Estimates of total costs are required and updated each period as the project progresses
- More accurate matching of revenues and expenses than alternative methods
- Widely used in the construction industry for long-term contracts
The percentage of completion method provides a truer financial picture for construction firms with jobs spanning multiple periods. By recognizing revenues and expenses throughout a project, it avoids the lumpiness issues of alternative accounting methods.
How to calculate percentage completion of a construction project?
To determine the percentage of completion for a construction project using the percentage-of-completion method, you need to follow these key steps:
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Calculate the total estimated costs for the construction project. This includes all direct and indirect costs required to complete the project.
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Determine the costs incurred to date. This includes actual costs spent on materials, labor, equipment, subcontractors, etc.
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Divide the costs incurred to date by the total estimated costs and multiply by 100 to get the percentage completion.
For example, if the total estimated costs for a project are $1,000,000 and the costs incurred to date are $400,000, the percentage completion would be calculated as:
Percentage Completion = (Costs Incurred to Date / Total Estimated Costs) x 100
Percentage Completion = ($400,000 / $1,000,000) x 100 = 40%
The percentage completion is used to recognize revenues and expenses in the financial statements over the course of the project using the percentage-of-completion accounting method as outlined in IFRS 15.
Construction companies should track percentage completion each month and make the appropriate adjusting journal entries to recognize revenues, costs, and gross profit margins. Using a percentage completion spreadsheet can help easily calculate and track the metrics month-over-month.
How to calculate percentage of work completed in contract account?
The percentage of completion method is used to recognize revenue and expenses over time for long-term construction projects. Here is an overview of how to calculate the percentage completed:
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Calculate total costs incurred to date. This includes all direct costs related to materials, labor, equipment, etc.
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Estimate total costs for the entire project. Develop a detailed budget estimating all costs to complete the project.
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Divide total costs incurred by total estimated costs to calculate percent complete:
Percent Complete = Total Costs Incurred / Total Estimated Costs -
Multiply the percent complete by the total contract amount to determine revenue to recognize for the period:
Revenue to Recognize = Percent Complete x Total Contract Amount -
Recognize expenses based on the percent complete calculation as well.
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Update calculations each period as project progresses.
An example:
- Total costs incurred to date: $2,000,000
- Total estimated costs: $10,000,000
- Percent complete = $2,000,000 / $10,000,000 = 20%
- Contract amount: $5,000,000
- Revenue to recognize = 20% x $5,000,000 = $1,000,000
Following the percentage of completion method ensures revenue, expenses, and profit are accurately reflected on financial statements throughout the project lifecycle. Careful tracking and budgeting are critical to calculate percent complete each period.
What is the CCM method of accounting?
The completed contract method (CCM) is an accounting technique that allows companies, especially those in the construction industry, to defer recognizing revenues and expenses related to long-term contracts until the contracts are completed or substantially completed.
Key Features
- Revenues, costs, and profits are not recognized until the contract is at least 90-95% complete.
- Better matches expenses to related revenues.
- Reduces impact of early stage losses on financial statements.
- More complex accounting compared to percentage of completion method.
The CCM method is beneficial for construction companies undertaking large, complex projects that span multiple reporting periods. By delaying income statement recognition, it eliminates the effects of early stage losses and better aligns reporting of revenues with related expenses.
However, a drawback is that financial statements in early periods of long projects do not reflect ongoing construction activities. Also, CCM relies heavily on accurate estimates of final costs and revenues to determine completion percentages and profit margins.
Overall, the completed contract method provides flexibility in accounting for long-term construction projects but requires careful tracking to allocate costs and revenues to the appropriate reporting period.
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Understanding the Percentage-of-Completion Method Formula
The percentage-of-completion method is an accounting technique used in long-term construction contracts to recognize revenues and expenses over the contract period, based on the percentage of work completed in a given period.
The percentage-of-completion method formula
The core formula is:
Percentage complete = Costs incurred to date / Total estimated costs
To calculate revenue for the period:
Revenue = Percentage complete x Total contract value
Expenses are recognized in proportion to the percentage of completion. This enables systematic revenue and expense recognition over the course of the project.
Applying IFRS 15 to the percentage-of-completion method
Under IFRS 15 revenue accounting standards, construction companies must:
- Identify contract obligations and performance milestones
- Reliably estimate total costs and revenues
- Objectively calculate percentage completion based on outputs or inputs
- Recognize revenues and expenses systematically based on percentage completion
- Continuously reassess estimates and adjust accounting accordingly
Adhering to these principles enhances the accuracy of financial reporting under this method.
Systematic revenue and expense allocation
The percentage-of-completion method matches revenues, expenses, and progress over the contract term. This avoids front- or back-loading of revenues/expenses into certain periods.
Accountants can thus systematically allocate revenues and expenses on construction projects over time as work is completed. This leads to financial statements better reflecting business activity and performance.
Calculating Work Completed in Construction Projects
This section focuses on the practical aspects of calculating the percentage of work completed in construction and its implications for revenue recognition.
How to calculate percentage of work completed in construction
To calculate the percentage of work completed on a construction project, the key steps are:
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Determine total budgeted contract costs: Add up all expected costs to complete the project, including materials, labor, subcontractor fees, equipment rentals, etc.
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Calculate costs incurred to date: Add up all actual costs spent on the project so far. This includes costs of materials used, labor hours worked, equipment rentals accrued, subcontractor invoices paid, etc.
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Divide costs incurred by total budgeted costs: Take the total costs incurred so far and divide it by the total budgeted costs for the project. This percentage indicates how much of the total project is completed.
Formula:
Percentage of Completion = Costs Incurred to Date / Total Budgeted Contract Costs
Some key considerations when calculating percentage of completion:
- Update calculations each month to account for new costs
- Carefully track all actual costs incurred against project budgets
- Monitor any change orders that may impact total budgeted costs
- Account for materials purchased but not yet used on the project
Percentage-of-completion calculation example
Let's look at an example to demonstrate calculating percentage of completion during a construction project:
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Total budgeted costs: $2,000,000
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Costs incurred in Month 1: $300,000
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Calculation: $300,000 / $2,000,000 = 15% complete
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Costs incurred in Month 2: $500,000
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Calculation: $500,000 / $2,000,000 = 25% complete
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Costs incurred in Month 3: $800,000
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Calculation: $800,000 / $2,000,000 = 40% complete
As we can see, the percentage completion climbs each month as more costs are incurred. Carefully tracking these percentages allows the contractor to recognize revenue over time as the project progresses.
This example illustrates how using the costs incurred to date against total budgeted costs allows construction firms to calculate percentage of completion and recognize revenue based on project progress.
Journal Entries for the Percentage-of-Completion Method
This section will illustrate the journal entries required over the duration of a construction project using percentage-of-completion.
Entries when costs are incurred
When project costs are incurred each period, they must be properly capitalized based on the percentage completion.
- As costs are incurred throughout the project, they are debited to the Construction in Progress account. This captures all costs associated with the project.
- Based on the percentage of completion, the appropriate portion of costs is then reclassified from Construction in Progress to an inventory account called Cost of Uncompleted Contracts. This represents costs allocated to work completed to date.
- For example, if total budgeted costs are $100,000 and at the end of Year 1 the project is 30% complete, $30,000 of costs would be reclassified from Construction in Progress to Cost of Uncompleted Contracts.
Entries when revenues are recognized
Revenues also need to be systematically recognized each period based on the updated % complete figures.
- As work is completed, revenue is calculated based on the percentage completion and total budgeted/contracted revenue.
- This revenue is initially recorded in an account called Unearned Revenue. It represents revenues that have been billed but not yet earned.
- The appropriate portion of revenue is then reclassified from Unearned Revenue to an account called Earned Revenue, based on the percentage completion. This represents revenues earned to date.
End-of-project closing entries
After final costs and revenues are tallied, closing entries are required to zero out the temporary construction in progress accounts.
- The final Cost of Uncompleted Contracts balance is closed out to Cost of Goods Sold. This captures all costs associated with the completed project.
- The final Unearned Revenue balance is closed out to Revenue. This captures all revenue associated with the completed project.
- Any remaining balance in Construction in Progress is closed out to Cost of Goods Sold. This zeros out the temporary construction account.
Percentage-of-completion accounting journal entries
Below are some examples of journal entries that would be made over the course of a construction project using the percentage-of-completion method:
| Date | Transaction | Debit | Credit |
|---|---|---|---|
| Jan 1 | Construction costs incurred | Construction in Progress: $10,000 | Accounts Payable: $10,000 |
| Mar 31 | 30% of project completed | ||
| (30% x $100,000 total budgeted costs = $30,000) | Cost of Uncompleted Contracts: $30,000 | Construction in Progress: $30,000 | |
| Mar 31 | Billed $50,000 | ||
| (50% x $100,000 total contracted revenue) | |||
| 50% complete | Accounts Receivable: $50,000 | Unearned Revenue: $50,000 | |
| Mar 31 | Recognize revenue on work completed | ||
| (30% x $100,000 total contracted revenue = $30,000) | Unearned Revenue: $30,000 | Earned Revenue: $30,000 | |
| Dec 31 | Remaining costs incurred | Construction in Progress: $60,000 | Accounts Payable: $60,000 |
| Dec 31 | 100% of project completed | Cost of Uncompleted Contracts: $70,000 | Construction in Progress: $70,000 |
| Dec 31 | Recognize remaining revenue | Unearned Revenue: $50,000 | Revenue: $50,000 |
| Dec 31 | Close out temporary accounts | Cost of Goods Sold: $100,000 | Cost of Uncompleted Contracts: $100,000 |
Utilizing a Construction Percentage-of-Completion Spreadsheet
Construction percentage of completion spreadsheet
Spreadsheets can be a useful tool for tracking the percentage of completion on construction projects. Here are some tips for designing a construction percentage of completion spreadsheet:
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Include columns for key data like project name, start/end dates, budget, costs to date, estimated costs to complete, etc. This provides an overview of each project.
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Have a dedicated column for % complete that uses a formula to automatically calculate based on costs. For example:
% Complete = Costs to Date / (Costs to Date + Estimated Costs to Complete). -
Use conditional formatting to highlight projects that are over/under budget or behind schedule. This makes it easy to identify issues.
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Add graphs and charts like line charts showing % complete over time to visualize progress.
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Link to supporting documents like budgets, invoices, change orders, etc. to have all project information in one place.
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Set up summary dashboards to roll up high-level completion and financial data from multiple projects.
Integrating spreadsheets with accounting software
While spreadsheets are useful for tracking percentage of completion, integrating them with accounting software has some major benefits:
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Avoid manual data entry by importing actual costs from your accounting system into the spreadsheet automatically. This saves significant time.
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Minimize errors by ensuring the data matches between systems. Manual entry often leads to inaccuracies.
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Generate financial reports and invoices directly from your accounting platform using the percentage completion data. This streamlines billing and revenue recognition.
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Retain detailed backup for percentage completion calculations within your accounting system in case of audits. This provides transparency and accountability.
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Analyze data in a single source of truth instead of manipulating data across disconnected systems. This enables better insights.
Overall, linking spreadsheets with platforms like QuickBooks or Sage can optimize construction project accounting and unlock deeper financial analysis capabilities. The integrated approach leads to greater efficiency, accuracy and transparency.
Key Advantages and Limitations of the Percentage-of-Completion Method
Main benefits of percentage-of-completion
The percentage-of-completion method enables companies to recognize revenue and expenses systematically over the life of long-term construction projects. Rather than waiting until project completion to record all revenue, companies can match revenue recognition to project performance.
Key advantages include:
- Revenue recognition tied directly to percentage of work completed. This avoids front or back-loaded revenue.
- Better matches revenue with expenses incurred. More accurate financial reporting.
- Facilitates project management and oversight. Progress and budgets can be continually monitored.
- Early detection of issues. Problems can be addressed before completion.
- Aligns with accounting standards like IFRS 15 and ASC 606. Required for public companies.
Overall, the percentage-of-completion method provides a realistic picture of financial performance over the project lifespan.
Limitations to consider
While useful, the percentage-of-completion method relies heavily on accurate cost estimates and has some drawbacks:
- Revenue relies on cost estimates. Inaccurate estimates can distort financials.
- More complex calculations and journal entries required. Increased accounting workload.
- Revenue may fluctuate widely between accounting periods. Harder to forecast.
- Potential for unbilled receivables and liabilities on balance sheet.
Companies should have the capabilities to continually forecast costs and measure progress before implementing this method. It also may not be suitable for smaller, shorter projects.
In summary, the percentage-of-completion method brings complexity. Businesses should weigh the benefits against limitations based on their operations.
Conclusion and Next Steps
To wrap up, we'll summarize the core concepts and explore what accounting teams should focus on when leveraging percentage-of-completion.
Summary of key learnings
In closing, we reviewed essential percentage-of-completion concepts including:
- Its formula to calculate the percentage of completion based on costs incurred to date as a percentage of total estimated costs
- The revenue and expense recognition approach it enables, allowing for recognition over time rather than at project completion
- The journal entries required at each period end to record revenue, expenses, and receivables based on the percentage complete
Properly applying this method requires robust cost estimation and progress tracking to determine accurate completion percentages.
Next steps for implementation
Accounting teams new to this method should focus first on developing processes to enable precise completion percentage calculations, including:
- Creating detailed project budgets with line-item cost estimates
- Implementing progress reporting to capture costs incurred to date
- Building percentage-of-completion spreadsheets to automatically calculate percentages based on budget vs. actual costs
- Testing and refining estimation and reporting processes before full rollout
Getting these foundations right is key to leveraging percentage-of-completion successfully.
