Percentage-of-completion method

Definition

The percentage-of-completion method is an accounting approach used to recognize revenue and expenses associated with long-term contracts based on the progress made towards completion. This method allows companies to record revenue as work is performed, which provides a more accurate picture of financial performance over the life of a project. It connects financial reporting to the actual economic activities occurring during the contract period, making it crucial for construction and other long-term projects.

5 Must Know Facts For Your Next Test

1. The percentage-of-completion method is widely used in construction and manufacturing industries where projects extend over multiple accounting periods.
2. Under this method, revenue is recognized proportionately as work is completed, allowing for matching revenues with expenses incurred during the project.
3. To determine the percentage of completion, companies typically use either the cost-to-cost method or the efforts-expended method.
4. The choice of method can significantly affect a company's financial statements, impacting earnings quality and potentially raising red flags in financial reporting if not properly managed.
5. Proper documentation and estimates are critical in applying the percentage-of-completion method, as inaccurate projections can lead to misleading financial results.

Review Questions

• How does the percentage-of-completion method improve the accuracy of financial reporting for long-term contracts?
  • The percentage-of-completion method enhances financial reporting accuracy by allowing companies to recognize revenue as they make progress on a project, rather than waiting until completion. This reflects the actual economic activity and performance during the contract's duration. By aligning revenue recognition with project milestones, stakeholders receive a clearer view of a company's ongoing operations and profitability, making it easier to assess performance against expectations.
• What are some potential red flags associated with using the percentage-of-completion method in financial reporting?
  • Potential red flags include overly optimistic estimates of project completion that can inflate reported revenues and profits. If a company frequently revises its estimated costs or completion percentages, it may indicate poor management or lack of control over projects. Additionally, discrepancies between billings and costs incurred can signal cash flow issues or accounting manipulation. These factors can compromise earnings quality and raise concerns among investors and auditors.
• Evaluate the impact of improper application of the percentage-of-completion method on a company's financial health and investor trust.
  • Improper application of the percentage-of-completion method can severely distort a company's financial health by presenting an inflated view of revenue and profitability. Such discrepancies can mislead investors about the true performance and risk level of the business. If inaccuracies are discovered, they can lead to restatements of financial statements, which damage investor trust and can result in legal ramifications. Over time, this erosion of credibility may affect a company's stock price and its ability to raise capital in the future.

Related terms

Completed-contract method: An accounting method where revenue and expenses are recognized only when a project is completed, often used when the outcome of a contract cannot be reliably estimated.

Cost-to-cost method: A specific approach within the percentage-of-completion method that calculates progress based on the costs incurred to date relative to the total estimated costs of the project.

Billings in excess of costs: A situation where billings to customers exceed the costs incurred on a project, often impacting cash flow and financial reporting under long-term contracts.