Percentage-of-completion method

Definition

The percentage-of-completion method is an accounting technique used to recognize revenue and expenses based on the progress of a long-term project. This method allows companies to report revenues and expenses in relation to the degree of completion of the project, offering a more accurate reflection of financial performance over time. It is especially relevant for construction and contract-based industries, where projects span multiple accounting periods.

5 Must Know Facts For Your Next Test

1. The percentage-of-completion method is often applied in industries like construction, shipbuilding, and large-scale manufacturing, where projects can take several months or years to complete.
2. Revenue is recognized based on the proportion of costs incurred to date compared to the total estimated costs of the project, allowing companies to reflect ongoing work in their financial statements.
3. This method helps to smooth out revenue recognition over time, providing stakeholders with a clearer picture of financial health and project profitability as work progresses.
4. Companies must have reliable estimates of total project costs and completion levels to use this method effectively, which often requires regular updates and revisions.
5. Using the percentage-of-completion method can lead to fluctuations in reported income, especially if project costs or timelines change unexpectedly.

Review Questions

• How does the percentage-of-completion method differ from the completed contract method in terms of revenue recognition?
  • The percentage-of-completion method recognizes revenue and expenses gradually based on the project's progress, while the completed contract method defers all revenue and expense recognition until the project is fully completed. This means that under the percentage-of-completion method, companies can report financial results that reflect ongoing work, providing a more accurate view of their financial situation throughout the duration of long-term projects. In contrast, using the completed contract method may lead to significant swings in income recognition at the end of a project.
• What are some challenges companies might face when applying the percentage-of-completion method?
  • Applying the percentage-of-completion method can be challenging due to the need for accurate estimates of total project costs and completion levels. Companies may struggle with fluctuations in project costs or delays, which can affect revenue recognition. Regular monitoring and adjustments are necessary to ensure that estimates remain valid throughout the project's life cycle. Additionally, inconsistent estimates can lead to restatements of prior financial results, impacting stakeholder trust.
• Evaluate the impact of using the percentage-of-completion method on financial reporting and decision-making for companies involved in long-term projects.
  • Using the percentage-of-completion method significantly impacts financial reporting by providing a continuous view of revenue and expenses related to ongoing projects. This approach allows stakeholders to assess financial performance in real-time rather than waiting until project completion. Consequently, it aids in better decision-making as management can track profitability trends and make timely adjustments based on current project status. However, reliance on estimates introduces risks, as inaccurate projections can mislead stakeholders about a company's actual financial health.

Related terms

Revenue Recognition: The accounting principle that determines when and how revenue is recognized and reported in financial statements.

Contract Accounting: A specialized accounting method used by companies involved in long-term contracts, focusing on revenue and expense recognition based on contract performance.

Completed Contract Method: An alternative accounting method for revenue recognition where revenue and expenses are recognized only when a project is completed.