Understanding Percentage of Completion vs. Completed Contract Methods in Construction Accounting

In the world of construction accounting, two common methods stand out: the percentage of completion method and the completed contract method. These approaches help contractors and construction businesses accurately report their income and expenses over the course of long-term projects. Understanding the differences between these methods is crucial for making informed financial decisions and staying compliant with accounting standards.

What is the Percentage of Completion Method?

The percentage of completion method is an accounting technique that recognizes revenue and expenses as a project progresses. This method is widely used in the construction industry, especially for long-term contracts that span multiple accounting periods.

How Does the Percentage of Completion Method Work?

Under this method, revenue is recognized based on the percentage of work completed during each accounting period. The percentage is typically calculated by comparing the costs incurred to date with the total estimated costs for the entire project.

For example, if a construction company has incurred $500,000 in costs on a project with an estimated total cost of $1,000,000, the percentage of completion would be 50%. The company would then recognize 50% of the total contract revenue in that accounting period.

Advantages of the Percentage of Completion Method

• Provides a more accurate representation of a company’s financial performance over time
• Allows for better matching of revenues and expenses
• Helps in forecasting cash flows and planning resources
• Preferred by many investors and lenders for assessing a company’s financial health

Disadvantages of the Percentage of Completion Method

• Requires accurate cost estimates and ongoing project monitoring
• Can be complex to implement and maintain
• May lead to revenue recognition issues if estimates are inaccurate
• Not suitable for projects with uncertain outcomes or highly variable costs

What is the Completed Contract Method?

The completed contract method is an alternative accounting approach where revenue and expenses are only recognized when a project is fully completed. This method is often used for shorter-term projects or when the outcome of a contract is uncertain.

How Does the Completed Contract Method Work?

Under this method, all costs associated with a project are accumulated in a balance sheet account as work in progress. Revenue is not recognized, and profit is not reported until the entire project is completed. Once the contract is finished, the total revenue and all associated costs are recorded in the income statement.

Advantages of the Completed Contract Method

• Simpler to implement and maintain compared to the percentage of completion method
• Provides a more conservative approach to revenue recognition
• Suitable for projects with uncertain outcomes or highly variable costs
• Can be beneficial for tax purposes in certain situations

Disadvantages of the Completed Contract Method

• May not accurately reflect a company’s ongoing financial performance
• Can lead to significant fluctuations in reported income between accounting periods
• May not provide timely information for decision-making purposes
• Less preferred by investors and lenders for assessing a company’s financial health

Choosing Between the Two Methods

Deciding which method to use depends on various factors, including the nature of your projects, your company’s financial goals, and regulatory requirements. Here are some guidelines to help you choose:

Consider Using the Percentage of Completion Method When:

• You have long-term projects spanning multiple accounting periods
• You can make reliable estimates of project costs and progress
• You want to provide a more accurate picture of your company’s ongoing financial performance
• Your contracts have a high likelihood of completion

Consider Using the Completed Contract Method When:

• You have shorter-term projects or those with uncertain outcomes
• You cannot make reliable estimates of project costs or progress
• You prefer a more conservative approach to revenue recognition
• You want to simplify your accounting processes

Regulatory Considerations

When choosing between these methods, it’s important to consider regulatory requirements and accounting standards. In the United States, the Financial Accounting Standards Board (FASB) provides guidance on revenue recognition for long-term contracts.

Under the current accounting standards, the percentage of completion method is generally preferred for long-term contracts when certain criteria are met. However, the completed contract method may be allowed in specific circumstances, such as when reliable estimates cannot be made.

Impact on Financial Statements

The choice between these two methods can significantly impact your company’s financial statements. Here’s how each method affects key financial metrics:

Percentage of Completion Method:

• Revenue and profit are recognized gradually over the project’s life
• Balance sheet shows unbilled receivables or unearned revenue
• Income statement reflects ongoing project performance
• Cash flow statement may show differences between recognized revenue and actual cash receipts

Completed Contract Method:

• Revenue and profit are recognized only upon project completion
• Balance sheet accumulates costs as work in progress
• Income statement shows large fluctuations between accounting periods
• Cash flow statement may not align with reported income during the project

Best Practices for Implementation

Regardless of which method you choose, implementing best practices can help ensure accurate financial reporting and compliance with accounting standards:

1. Develop Robust Cost Estimation Processes

Accurate cost estimates are crucial, especially for the percentage of completion method. Invest in tools and training to improve your estimation capabilities.

2. Implement Strong Project Management Systems

Effective project management helps track progress, manage costs, and identify potential issues early on.

3. Regularly Review and Update Estimates

As projects progress, continuously review and update your cost estimates and completion percentages to ensure accuracy.

4. Maintain Detailed Documentation

Keep thorough records of all project-related costs, estimates, and calculations to support your financial reporting.

5. Consult with Accounting Professionals

Work with experienced accountants or CPAs who specialize in construction accounting to ensure compliance with relevant standards and regulations.

Conclusion

Choosing between the percentage of completion and completed contract methods is a critical decision for construction businesses and contractors. Each method has its advantages and challenges, and the right choice depends on your specific circumstances and goals.

By understanding these methods and implementing best practices, you can improve your financial reporting, make better-informed decisions, and position your business for long-term success in the competitive construction industry.

Remember, while this article provides an overview of these accounting methods, it’s always best to consult with a qualified accounting professional for advice tailored to your specific situation and local regulations.