Percentage-of-completion method

Definition

The percentage-of-completion method is an accounting technique used to recognize revenue for long-term contracts as work progresses, rather than waiting until the contract is fully completed. This approach allows businesses to match revenues with expenses in the same period, reflecting the economic reality of ongoing projects. It's especially relevant for industries like construction and franchises, where revenue can be significant and spread out over several years.

5 Must Know Facts For Your Next Test

1. Under the percentage-of-completion method, revenue is recognized based on the completion percentage of the project, which is calculated using various metrics such as costs incurred or labor hours worked.
2. This method provides more timely financial information, allowing stakeholders to see progress on contracts and make better decisions based on current performance.
3. Contractors using this method must provide reliable estimates of total project costs to ensure accurate revenue recognition throughout the project's duration.
4. While advantageous for long-term contracts, this method requires careful tracking of costs and revenues to comply with accounting standards and avoid misstatements.
5. The method can be particularly beneficial in franchise operations, where revenue from franchise fees can be recognized as franchisees open new locations and begin operations.

Review Questions

• How does the percentage-of-completion method improve the accuracy of financial reporting for long-term contracts?
  • The percentage-of-completion method improves financial reporting accuracy by aligning revenue recognition with the actual progress of a project. By recognizing revenue as work is completed rather than waiting for project completion, companies provide a clearer picture of their financial health. This approach allows stakeholders to better assess ongoing project performance and understand the timing of cash flows associated with long-term contracts.
• In what ways does the percentage-of-completion method interact with revenue recognition principles, especially concerning estimates and reliability?
  • The percentage-of-completion method closely aligns with revenue recognition principles by emphasizing the need for reliable estimates of total contract costs. Accurate revenue recognition depends on assessing the project's progress correctly, which involves estimating future expenses and revenues. Companies must apply judgment in determining these estimates, ensuring they are reasonable and supportable to comply with accounting standards while also avoiding potential financial misrepresentation.
• Evaluate how the percentage-of-completion method impacts franchise operations compared to traditional revenue recognition methods.
  • The percentage-of-completion method significantly impacts franchise operations by allowing franchisors to recognize revenue from franchise fees as new franchises open and begin generating sales. This contrasts with traditional methods where revenue is only recognized at the point of sale or upon contract completion. By using this method, franchisors can reflect their ongoing support and resources provided to franchisees more accurately in their financial statements, leading to a more dynamic understanding of revenue streams and business performance over time.

Related terms

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

Cost-to-Cost Method: A specific way of calculating the percentage of completion, where revenue is recognized based on the costs incurred relative to total estimated costs.

Franchise Agreement: A legal contract between a franchisor and franchisee that outlines the rights and obligations of both parties, including revenue sharing and operational guidelines.