Estimating the revenues and expenses for a project is not as straightforward as it is a continuous process. Therefore, companies must use various approaches to assess them. One of those approaches is the percentage of completion method.
What is the Percentage of Completion Method?
The percentage of completion method is an accounting approach commonly used in long-term projects, particularly construction and production. Unlike other methods that defer revenue recognition until the project’s completion, this method allows for the gradual recognition of revenue and expenses as the project advances.
The process involves estimating the revenue and costs of the project. Afterward, it entails determining the percentage of completion at specific intervals and recognizing the percentage of the total revenue and costs in the financial statements. This approach aligns with the matching principle, providing a more accurate portrayal of a project’s financial performance over time.
How does the Percentage of Completion Method work?
The percentage of completion method is an accounting approach designed for long-term projects, particularly prevalent in industries like construction and manufacturing. Its operation requires estimating the total revenue and costs expected at the project’s commencement. As the project unfolds, periodic assessments are conducted to ascertain the percentage of completion.
The percentage of completion comes from physical progress, incurred costs, or other measurable benchmarks. The crux of this method lies in the gradual recognition of revenue and associated costs in proportion to the project’s completion status. For instance, if a project is 60% complete, 60% of the total estimated revenue and costs would be reflected in the financial statements.
What is the formula for the Percentage of Completion Method?
The percentage of completion method formula involves dividing the costs incurred to date for a project over its total estimated cost, calculated as below.
Percentage of completion = (Costs incurred to date / Total estimated costs) × 100
As the name suggests, this formula provides a percentage of completion for the project, which companies use for accounting purposes.
Example
Red Co., a construction company, is currently engaged in a significant construction project with a total estimated cost of $1,000,000. As of the end of the first quarter, the costs incurred on the project amount to $250,000. In adopting the percentage of completion method, Red Co. seeks to accurately reflect the project’s financial status as it progresses, aligning with the matching principle in revenue recognition.
Red Co. uses the formula for the percentage of completion method as demonstrated below.
Percentage of completion = (Costs incurred to date / Total estimated costs) × 100
Percentage of completion = ($250,000 / $1,000,000) x 100
Percentage of completion = 25%
What are the advantages and disadvantages of the Percentage of Completion Method?
The percentage of completion method presents several advantages for businesses engaged in long-term projects. Firstly, it ensures accurate revenue recognition by reflecting earned revenue proportionate to the project’s completion status. This method facilitates timely financial reporting, providing stakeholders with current and relevant information on the project’s financial health and enabling informed decision-making.
Despite its advantages, the percentage of completion method comes with some challenges. One notable drawback is its complexity, as accurate calculations require careful assessment of project completion and total costs, making it susceptible to errors. There’s a risk of misrepresentation if estimates are inaccurate, potentially leading to financial statement restatements or disputes.
Conclusion
The percentage of completion method is an accounting approach that helps companies recognize project revenues and expenses in line with the matching principle. The formula requires dividing the costs incurred to date by the total estimated costs. The percentage of completion method has various advantages and disadvantages listed above.
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