Percentage-of-completion method

Definition

The percentage-of-completion method is an accounting technique used to recognize revenue and expenses for long-term contracts based on the progress of the project. This method allows companies to report income and expenses proportionate to the work completed during an accounting period, providing a more accurate picture of financial performance over time. By recognizing revenue as construction progresses, companies can match income with related costs, reflecting a more realistic view of ongoing projects.

5 Must Know Facts For Your Next Test

1. Under the percentage-of-completion method, revenue is recognized based on the estimated completion percentage, which is often determined through measures such as costs incurred or milestones achieved.
2. This method is particularly useful in industries like construction and engineering, where projects can span multiple accounting periods and require ongoing performance assessments.
3. Estimating costs and completion percentages accurately is crucial, as inaccuracies can significantly impact reported earnings and financial position.
4. Companies must disclose their accounting policies related to revenue recognition, including any assumptions made in estimating project completion, to provide transparency to stakeholders.
5. The percentage-of-completion method can enhance cash flow management by allowing companies to recognize revenue earlier, which can support financing and investment decisions.

Review Questions

• How does the percentage-of-completion method improve financial reporting for long-term contracts compared to other methods?
  • The percentage-of-completion method improves financial reporting by allowing companies to recognize revenue and expenses based on actual work completed during an accounting period. This contrasts with methods like completed-contract, which delays recognition until project completion. By matching income with ongoing costs, this method provides a clearer view of financial performance and helps stakeholders understand project profitability over time.
• Discuss the potential risks and challenges associated with using the percentage-of-completion method for revenue recognition.
  • One major risk of using the percentage-of-completion method is the reliance on accurate estimates for project completion and costs. If these estimates are overly optimistic or pessimistic, it can lead to significant distortions in reported earnings. Additionally, changes in project scope or unforeseen delays can complicate the assessment of progress. Companies must have robust processes for monitoring and updating estimates to mitigate these risks and ensure reliable financial reporting.
• Evaluate the implications of adopting the percentage-of-completion method on a company's financial statements and investor perceptions.
  • Adopting the percentage-of-completion method can significantly affect a company's financial statements by enabling earlier recognition of revenue and profits, thus enhancing reported financial performance. This early recognition can positively influence investor perceptions, as it reflects growth and ongoing operational success. However, if a company frequently revises estimates or reports significant variances from projected revenues, it could raise concerns about management's ability to forecast accurately. Overall, while this method can improve cash flow management, it also requires transparency and careful monitoring to maintain investor confidence.

Related terms

completed-contract method:

An alternative accounting method where revenue and expenses are recognized only when a project is completed, often leading to more volatility in reported earnings.

cost-to-cost method: A specific approach under the percentage-of-completion method that calculates the percentage of completion based on the costs incurred to date compared to total estimated costs.

contractual obligations: Legal commitments made by parties involved in a contract, defining what each party is required to fulfill within the terms of the agreement.