Percentage-of-completion method

Definition

The percentage-of-completion method is an accounting approach used to recognize revenue and expenses based on the progress of a long-term project. This method allows companies to match revenue with the costs incurred as work on the project progresses, providing a more accurate financial picture over time. It's especially relevant in industries like construction and engineering, where projects often span multiple accounting periods.

5 Must Know Facts For Your Next Test

1. Under the percentage-of-completion method, revenue is recognized based on the proportion of work completed at a given time, often calculated using costs incurred versus total estimated costs.
2. This method improves the matching of revenues with expenses, which enhances financial reporting and analysis for ongoing projects.
3. It is typically used for long-term contracts that last more than one accounting period, making it crucial for industries like construction and software development.
4. Companies must estimate total project costs and the stage of completion, which can introduce significant judgment and variability into financial reporting.
5. The percentage-of-completion method is governed by specific accounting standards, such as ASC 606 in the U.S., which outlines criteria for recognizing revenue over time.

Review Questions

• How does the percentage-of-completion method differ from the completion method in terms of revenue recognition?
  • The percentage-of-completion method recognizes revenue gradually as a project progresses, allowing companies to report revenue based on the amount of work completed at any given time. In contrast, the completion method recognizes all revenue only when a project is fully completed. This difference is significant because it affects how a company's financial health is portrayed over time, particularly in industries where long-term projects are common.
• Discuss the challenges companies might face when using the percentage-of-completion method for revenue recognition.
  • Companies face several challenges when using the percentage-of-completion method. These include accurately estimating total project costs and determining the stage of completion, which requires significant judgment. Additionally, changes in project scope or unforeseen expenses can affect profitability estimates, potentially leading to adjustments in reported revenues and expenses. This variability can complicate financial forecasting and may lead to financial statement restatements if estimates prove inaccurate.
• Evaluate how the adoption of ASC 606 has impacted the implementation of the percentage-of-completion method in companies' financial reporting practices.
  • The adoption of ASC 606 has significantly refined how companies implement the percentage-of-completion method. This standard emphasizes the importance of identifying performance obligations and measuring progress towards their satisfaction. It has led to greater transparency in financial reporting as companies are required to disclose more about their contracts and revenue recognition policies. Additionally, this change aims to standardize practices across industries, potentially making financial comparisons between companies more straightforward while also ensuring that revenue reflects the actual economic realities of ongoing projects.

Related terms

Revenue Recognition:

The accounting principle that dictates when and how revenue is recognized in financial statements, ensuring it reflects the actual economic activity.

Contract Accounting: A specialized area of accounting focused on tracking and managing the financial aspects of contracts over their duration, including revenues, expenses, and profit recognition.

Completion Method: An accounting method where revenue and expenses are recognized only once a project is fully completed, contrasting with the percentage-of-completion method.