The standards known as generally accepted accounting principles (GAAP) require a business to recognize its revenues in a way that matches closely with its expenditures and to accrue those revenues within the same accounting period as the expenses.
- The installment method and the percentage-of-completion method are typically used by contractors who incur expenses month to month but are paid only on delivery of the project.
- Each accounting method allows for delayed revenues to be counted against immediate expenses.
- The percentage-of-completion method is primarily used by contractors on large long-term projects.
The installment method and the percentage-of-completion method are each revenue recognition structures specifically designed for businesses that operate under contract on large projects which may take months or years to complete. Some examples include construction companies, real estate developers, and engineers.
For investors, understanding these two methods is essential to determining the profitability and sustainability of these types of companies.
The Installment Method
The installment method is suitable for construction companies, especially home builders, as they routinely make contracts to build and receive only some revenues before and during the project, with most paid at the completion of the project.
Meanwhile, the costs add up, and building materials must be paid for along the way, regardless of whether revenues are received.
To use the installment method, there must be revenues to match the expenses incurred.
Example of Installment Accounting
For example, if a home is to be built at a contracted price of $300,000, and the builder's cost is $200,000, the builder might accept a $5,000 down payment.
The builder calculates the gross profit for the entire transaction, then applies that proportionately to the revenues as they are received. For the first month, during which the $5,000 down payment was received, the builder would take the gross profit percentage of 67% ($200,000/$300,000) and record the down payment as $3,350 ($5,000 x 0.67) gross profit.
The calculations assume the entire sales price will be collected. So, this method will overstate gross profits if the final payment is not received.
The percentage-of-completion method is also used by many builders, although generally by those handling longer-term contracts for big projects such as the construction of an office building.
Using this method, revenues and expenses are recorded based on how much work has been completed.
To use this method, the project must lend itself to identifiable stages of completion so that specific costs can be attributed to each stage. The company reports earnings using an estimated total cost against incurred expenses or specific milestones, such as how many floors are completed.
Example Using the Milestone Approach
For example, using the milestone approach, a contractor undertaking the construction of a 10-story office building might calculate the cost per floor at $100,000. The company calculates revenue and expenses for each completed floor. If the sale price of the building is $5 million, and four floors have been completed, this is calculated as $1.25 million of revenue and $400,000 in expenses for a gross profit of $850,000.
For the cost approach, the builder determines the estimated gross profit for the project to be $4 million. With the building 40% complete, and $400,000 in expenses, the revenues can be accrued as $1.6 million ($4 million x 0.40).
The percentage-of-completion method can overstate gross profit if expenses are contributed to the work before it is actually completed.