When construction or engineering firms take on long-term projects, recognizing revenue and tracking expenses can become complex. The percentage-of-completion accounting method offers a reliable solution that aligns financial reporting with project progress and helps firms comply with accounting standards.
Percentage-of-completion accounting follows a simple principle: revenue should be recognized as costs are incurred and work is completed. By aligning revenue with a project’s progress, this method gives companies clearer insight into the financial performance of each contract.
In addition, reporting expenses and revenue annually helps spread tax liabilities across multiple years, potentially lowering taxable income in a given year and enabling the write-off of qualifying expenses
Comparing Percentage of Completion With Completed Contract Accounting
To better understand the percentage-of-completion accounting method, it may be helpful to compare it with the completed contract method. The latter recognizes revenue only when the project is fully complete. Under this method, costs and revenue are also matched when the project is completed.
The potential advantages of the completed contract method include its simplicity, and the deferral of tax liability (since revenue recognition is delayed until the project is finished). Potential drawbacks include the fact that the method doesn’t reflect a project’s ongoing performance (which may create an inaccurate understanding of the project’s profitability) and that revenue is recognized as a lump sum at completion.
This can distort financial ratios and forecasts if a project’s completion takes longer than anticipated. The completed contract method is also limited to contractors whose average annual gross receipts for the three preceding tax years does not exceed $30 million for tax years beginning in 2024, or $31 million for tax years beginning in 2025.
In contrast, percentage-of-completion provides a more accurate understanding about a project’s performance by matching revenue with work as it’s performed. It also increases overall performance evaluation and forecasting by smoothing out revenue recognition over a project’s life.
A potential disadvantage of percentage-of-completion is the higher administrative burden associated with tracking and documenting a project’s status.
The Advantages of Percentage of Completion
The percentage of completion method offers several advantages for long-term construction or engineering projects:
- Improved financial accuracy. Percentage of completion provides a more accurate representation of a company’s financial status during each reporting period by reflecting the value created as a project progresses and aligning revenue recognition with the completed work.
- Enhanced transparency. Percentage of completion results in financial statements that better reflect the value created over time. This financial clarity can be beneficial for investors, lenders, sureties, and customers who rely on up-to-date information for decision-making.
- Compliance with accounting standards. The percentage of completion method aligns with Generally Accepted Accounting Principles (GAAP) and, if applicable, International Financial Reporting Standards (IFRS).
Maintaining Accuracy Throughout the Project Lifecycle
To fully realize these benefits, companies must track estimated and actual costs throughout a project’s life. This requires ongoing coordination with the project managers in the field to ensure the project is progressing as expected.
As projects evolve, estimates may need to be adjusted to reflect change orders or contractual adjustments (ideally before the project is completed). Good estimates, along with regular job cost reviews and updates, are essential for maintaining accuracy.
Clear documentation of performance obligations and change orders, along with strong collaboration between project management, accounting, and legal teams, further supports accurate reporting.
Common challenges, such as accounting for cost overruns, project delays, or handling contract claims and disputes, can influence costs and estimates. Failing to monitor expenses and progress accurately during a project’s lifecycle can result in revenue and costs being recorded in the wrong period.
Balance Sheet Effects of Percentage of Completion
Because contract billings rarely align precisely with a project’s progress, the percentage of completion method usually has balance sheet effects that account for any differences.
For example, consider a two-year construction project with a contract valued at $1 million. The contractor expects the project to cost $800,000 to complete and to generate $200,00 in profit.
If the contractor incurs half of the expected costs in the first year ($400,000) and bills the customer $450,000, the contactor will recognize half of the contract’s value ($500,000) as revenue and record the $50,000 ($500,000 in revenue recognized less $450,000 in actual billings) in underbilling as a contract asset on the balance sheet.
Similarly, if the contractor invoices $550,000 during the first year, the $50,000 in excess billings would appear on the balance sheet as a contract liability.
To learn more about the percentage of completion accounting and the benefits for your company, contact us.
